Are the Big Four Banks Partying Like it’s 2007?
Regular readers will be aware of the very strong run enjoyed by the Big Four banks recently, and of our view that the price rises have pushed them into somewhat expensive territory.
It is all but impossible to gauge when the tug of gravity will again make itself felt and prices will converge with values, but to try to give the issue some context we ran an analysis of financial metrics for the big 4 banks, comparing the position we see today with that which we saw in September 2007.
What we found is that valuations today look quite similar to valuations from September 2007. In margin of safety terms, we estimated an average of negative 14 per cent today vs negative 12 per cent in 2007, meaning slightly less favourable valuations today. If you view it in terms of earnings yield (or PE ratio), the picture is slightly more favourable today compared with 2007. This difference is partially explained by return on equity figures, which have declined somewhat in more recent times, possibly reflecting increased regulatory capital needed to generate a dollar of earnings.
Another interesting difference is that profit margins are higher today than they were in 2007. This may reflect a lower level of competition following the industry consolidation that accompanied the GFC. Over time, competition may return, but this is unlikely to happen quickly.
Finally (surprise, surprise) dividend payout ratios today are materially higher. Since 2007, the boards of the Big Four have lifted payout ratios by an average of around 10 percentage points. It is interesting to note that while they are sending cash out the door to the holders of ordinary shares, the banks are also gathering up capital by issuing hybrid securities to other yield-hungry investors at a rate of around $6 billion p.a. There is an element of moving cash from one pocket to another to take advantage of investor sentiment, but that’s the market we are operating in.
There is nothing especially alarming about these figures. While valuations stand at similar levels to 2007, this is still not a dramatic overvaluation, and share prices may remain buoyant for quite some time, especially if interest rates remain low.
In the long run however…well, you know the drill.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Michael Shapiro
:
I believe the ASX 200 market pullback is imminent. A number of trend related signals and magnitute of the latest up move point to it. As does the seasonality analysis. Statistically, the next two weeks are in the bottom 3 out of 52 weeks in the year. Index heavy banks going ex dividend at this time play an important part as well and serve as a catalyst for a market pullback. I believe the pull back will be major as the up move had a substantial magnitude. However this will not be the start of the bear market as easy money is set to continue for some time. Buying before christmas should be a great opportunity.
Roger Montgomery
:
Thanks Michael,
I for one will be fascinated now to see how it plays out.
Ronald Ju-Chiang peng
:
We all agree that Australia is becoming less competitive. Any plans to open a Montgomery fund that invests in international shares (in US$ or other currencies) ?
Roger Montgomery
:
Its on the radar but still drifting in outer orbit. We have it in our plans but it will be rather specific in its remit.
Jeff T
:
Roger, I think the ASX200 is partying like its 2007
Roger Montgomery
:
You might like to read our post next week about Bubbles…
eric.cheung.7359
:
Tim, great post, and it matches my guessimate that for strong companies with a high ROE, the market is at around 2007 levels of valuation (using the simple valuation method Roger gives in Value.Able).
I was wondering what your team thinks about the current historically low interest rates. Does this affect your valuation of stocks by, for example, reducing your required rate of return? I believe Buffett once said that stock prices are most strongly correlated to two things:
1) EPS (correlated)
2) Interest rates (inversely correlated)
or as he said at the 2010 Berkshire AGM:
‘The pressure of extremely low rates can’t be underestimated. Afraid of everything else, pressure to put other prices back up will be enormous as fear gets resolved. You shouldn’t underestimate the degree to which the last year of stock prices is result of agony of very low interest rates. We have seen a lot of that, and we’ll see what happens when rates go up.’
Does an official cash rate of 2.5% instead of 7% goes some way to justifying inflated stock valuations as capital flees to anywhere that it can get a return?
Roger Montgomery
:
We would not change our own required returns. If you shift your discounts rates ever lower, you can be caught with your pants down when the tide goes out.
eric.cheung.7359
:
Sounds sensible – thanks Roger. Should Australia head to ZIRP and stay there for a long period of time like in the US, it might cause continued asset price inflation and distortions. As value investors we may or may not be in for an interesting time – perhaps the definition of ‘value’ will need to change somewhat.
Am an avid follower of your blog – keep up the great work and looking forward to seeing the continued success of the Montgomery fund.
Roger Montgomery
:
Thanks Eric. Lets revisit your ZIRP comment in 12 months. Its an interesting proposition.
jeffrey poon
:
Hi roger,
I commend you for not changing your required return, but are you suggesting the change in risk free return plays no part in your valuation assessment?
Roger Montgomery
:
That returns doesn’t change nearly as much as the academics might have you believe.