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Which bank?

Financial Services | Comments (114)

Which bank?

Everyone from the media, to politicians and litigation funders have been busy bashing our banks over the head. Led by a possibly tipped-off/advised Joe Hockey, this particular attack seems to have legs. Have you been distracted by the noise?

Not me, I have been busy looking at the latest set of financial results from ANZ, NAB and WBC and comparing them to my CBA benchmark.

I have spent many hours and analysed many industries and their KPI’s and for the banks I will simply say that CBA and WBC are currently my two highest quality banks (based on the Montgomery Quality Rating). WBC gets an A1 MQR (up from an A5!), CBA is an A2 (up from an A4). They’re also the biggest.

My salient facts for the big four are shown below.

While ANZ appears to be the cheapest and the most tempting, I continue focusing on the goal of filling the portfolio with only the best businesses. So it may prove a better option to exercise patience and wait for wider safety margins. With the latest round of bank bashing and China announcing further tightening measures, I may not have to wait long.

Between now and then you will read many views about the size of each bank’s reported profits, why they have too much power, why they should cut this fee or stop doing this and that. But keep in perspective that no matter what is written or said, they provide many services and functions that are vital to capitalism.

Another important couple of things to remember is that they collectively have 92% market share and don’t provide all (or any!) of their services for free. ATM Fees… Debit Card Transaction Fees… Annual account-maintenance fees… Monthly Account keeping Fees… Minimum Balance Fees… Wire Transfer Fees… Overdraft Protection Fees… Overdrawn fees… Dishonour Fees… Clearance Fees… Statement Fees… Voucher Fees… Periodical Payments or transfer fees… Stop payment fees… Recent Transaction List Fee… Overseas transaction fees… Electronic banking fees… Interest fees… Establishment Fees… Deferred establishment fees… Over the limit fees… Currency conversion fees… Annual Fees… Deposit Fees… Withdrawal Fees… Online-banking fees… Teller fees… the list goes on, there’s even “late” payments fees for paying your credit card too early.

As you might know there are four basic sources of competitive advantage – something Buffett is primarily focused on – they are: economies of scale, the network effect, intellectual property rights and high switching costs. The four biggest banks enjoy both economies of scale and the benefits of high switching costs. It is personally more taxing for a client to change banks than the benefits that inhere from switching. And so very few people switch. As I have often said, if you live on an island with a long swim to anywhere else, then owning a bank is not a bad idea. They can charge you to put your money in, charge you to take your money out and even charge you to find out how much money you have.

For me, being active in the share market can bring on-line brokerage fees, telephone order fees, custody fees, software fees, transfer fees, late settlement fees, margin lending fees etc…

No matter where you turn, the banks are entrenched in my daily life.

And where do all of these fees, along with net interest income and trading profits go? Into wafer thin 1% margins. Yes, our banks rely on massive volumes. WBC has $620b of assets. A 1% return on those assets equates to a profit of $6.2b – roughly what they reported in their full year result.

They are also some of Australia’s highest leveraged businesses shouldering enormous risks (albeit controlled) to generate that return. If you have ever heard that ‘X’ bank has a tier 1 risk weighted capital ratio of 8%, generally this means that the bank is holding only $8 for every $100 that a customer has borrowed. Being highly geared, it is therefore in the bank’s interest to ensure that everything in our economy ticks along.

By far the biggest variable expenses for banks are bad debts. During the GFC when bad debts increased dramatically, do you remember what happened when things turned ugly? Those wafer thin profit margins disappeared like the last Mars Polar Lander. The impact on NAB’s profits, for example, was dramatic with profit in 2009, $2 billion lower than the year before.

With these risks in mind it seems a tad irrational to quibble over the enormous profits being earned, particularly when they are largely returned to Australians. Shareholders receive 70%-80% of profits in fully franked dividends and the Australian public receive 30% of pre-tax profits via tax payments to the government.

On the other side of the coin is the very real fact that these are mature businesses. As Value.able Graduate Richard Quadrio mentioned in his comment here on the blog yesterday, banks can only increase their profit by either lending us more or charging us more. The former depends on our appetite, which may be slowing. That leaves the latter.

In my mind, they have the power to keep increasing prices but the legislators now need to be convinced that they should be allowed to in return for wanting to continue lending and perpetuating the GDP growth dream.  Paralysed by these competing forces, I go back to what I know – investing, and ask; which bank is the best? For me that’s the only question – which bank?

Posted by Roger Montgomery, 11 November 2011.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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.

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114 Comments

  1. jeff browne
    :

    Hi all and Merry Christmas.

    Looking for some help. Has anyone out there run the numbers for the iv of CBA? if so, are you using 10% or 12% return rate? Very interested in your thoughts as it makes a big difference to the IV?(obviously) also looks to me the roe is plateauing.

    Thanks in advance

    jeff

  2. Lloyd
    :

    Roger,

    Looks like NAB have just taken the Most Unpopular Bank crown from CBA.

    It is one thing to be charged too much by way of interest, another altogether when access to your money is denied!

    I cannot believe that NAB leadership relies on what they now quaintly call a “legacy computer system” to supply the core of their customer experience. This takes incompetence to previously unseen levels in the Australian Banking Sector!

    Regards
    Lloyd

  3. rowan
    :

    australian banks have about 14 trillion dollars in derivatives on there books (of balance sheet) more than enough to wipe out there entire capital base many times over.
    these otc derivatives brought down beare stearns, freddie/ fannie , lehman and AIG and a great unwind would have occured if not for government backstops.
    It was warren buffett has said the derivatives neutron bomb has the potential to destroy the entire world economy and is a disaster waiting to happen. Buffett also referred to derivatives as “weapons of mass destruction”.

  4. Rob
    :

    Hi Roger,
    Love your book times four, so far.
    This may have been covered in the hundred posts that precede mine.
    Banks are in a unique position where under fractional reserve banking they can create money (assets) through lending. Is it fair then to suggest a 1% margin when their loans equate to almost a half a trillion dollars?
    Roger, I have many books on investing (technical analysis, Buffett, Lynch, Munger and many more) and yours is by far the best.
    I have never tried TA. I cannot see my sitting in front of screen staring at charts for hours on end only to be “stopped” out because Wall St sneezed. And, all for meagre gains.
    I could not believe how many times, while reading Part One, a line or sentence would strike a chord with me.
    I have been “investing” in the market since 1998. When asked, I have always cautioned my friends they need to have the right temperament and be able to control fear, greed and regret.
    Part One just drives the message home so well that if you value invest you won’t need to worry about what the market and the herd is doing. It makes controlling those emotions so much easier.
    Cheers and thanks again
    Rob

    • Roger Montgomery
      :

      Thanks for those encouraging words. I am delighted the first part of the book is having the desired impact. I was ask the question about emotion and fears of a market correction on Sky Business last night and my response remains unchanged, looking at businesses provides the latitude to turn the noise off – I mean really turn it off.

  5. Tony Ryburn
    :

    It is interesting to look at the annualised returns of the banks over the last 10 years.

    ANZ 12.26% (Cap. 5.48% Div. 6.78%)
    CBA 12.54% (Cap. 6.28% Div. 6.26%)
    NAB 3.54% (Cap. -1.65% Div. 5.19%)
    WBC 13.11 (Cap. 5.96% Div. 7.15%)

    This is on a simple interest basis. The total returns on a compound basis are:
    ANZ 8.11%
    CBA 8.23%
    NAB 3.08%
    WBC 13.11%
    WBC 8.49

    Being a muture, stable sector with a good track record (in Australia if not elsewhere!) I think these figures are likely to give a good indication of what you might expect over the long run in future.

    The decision on whether to by bank shares should therefore have a lot to do with to how confident you are that you can better these returns elsewhere.

    It’s also interesting to compare the return on bank shares with what you would have earned if you had deposited your funds with the bank rather than investing in it. I would argue that in reality the credit risk you are incurring is pretty much the same either way.

    • Roger Montgomery
      :

      These are really useful insights and show that en Graham was right,; In the long run the market is indeed a weighing machine. Over long periods of time, the stock market performance will reflect the change in intrinsic value.

  6. ben
    :

    Was reading a post authored by Ray… Let me say, I believe there was a strenous stress test applied to the banks (APRA+ RBA really did apply the ‘doomsday’ scenario, a fall in residential property prices of about 25%, unemployment at about 11%, commerical property prices falling 45% and a shrinkage of GDP of around 3%) and from my knowledge the banks cleared the capital requirements with flying colours (never falling below the 4% requirement of T1 capital–> vanilla equity, reserves etc). Rest assured that our banks are a pillar of strength and with plans to meet the new Basel III changes (ie a rise to 7% T1 capital), I sincerely believe that if the worst were to materialise our banks would be a strong hold.

    however as we all know irrationalities dominate our beautifully imperfect traits, whether they could survive the dreaded ‘bank run’.. I dont know.

  7. Peter
    :

    Roger,
    In a recent comment on facebook regarding an article on banks which you have written for the Eureka Report, you say that “investors should only be buying at very big discounts to intrinsic value – which currently don’t exist”.

    Unless I’ve got it completely wrong, WBC appears to be trading at a reasonable (if not very big) discount to its IV. Would you or anyone else on the blog care to share your IV for WBC. According to my calculations and assuming a 10% RR, I’ve got a 2010 IV of $25.63.

    Thanks in advance to you and the wider community for any insights or feedback.

    Peter

      • Peter
        :

        Thanks for that Roger. Now that i know my IV for WBC is wayward, I’d appreciate any comments/guidance from fellow graduates on the following variables that I’ve used in arriving at my 2010 IV.

        EYE – $38,198m
        Shares – 2,989m
        EQPS – $12.78
        NPAT – $6,346m
        BYE (average) – $36,413m
        ROE – 17.43%
        Dividend – $3,694m
        POR – 58%
        RR – 10%
        IV – $27.63

        Thanks in advance for your help.

        Peter

      • Pat Fitzgerald
        :

        Hi Peter

        For the FY ending Sep 2010, I used the ‘Net Profit before Abnormals’ ($5,879m) and therefore the payout ratio I used is higher than 58% and the ROE lower than 17.43%; I therefore get a lower IV than you.

      • John M
        :

        Hi Peter,
        Using the WBC 2010 Annual Report, I get these figures, hope this helps.

        Current Equity 40118
        Prior Years Equity 36571
        Average Equity 38335
        Shares 2,989
        EQPS 13.42
        NPAT 6346

        ROE 16.55%
        ROE SELECTED 17.5%
        Dividend 4154
        POR 65%
        RR 12%
        IV $21.95

        The fido website of the Australian Securities and Investment commission have two good articles worth reading:

        1. Using annual reports to judge a company’s performance

        http://fido.asic.gov.au/fido/fido.nsf/byheadline/annual%20reports?opendocument

        2. How you can use company financial statements?

        http://fido.asic.gov.au/fido/fido.nsf/byheadline/How+you+can+use+company+financial+reports?openDocument

        Thought this might be helpful. I am guessing it should be impartial, independant information, being that it comes from ASIC.

      • Peter
        :

        Pat/John,

        Just wanted to thank you both for taking the time to respond to my enquiry which is much appreciated.

        Peter

  8. Alex
    :

    Hi Roger and Readers,

    I am sitting here studying for my advanced corporate finance exam tomorrow, a subject that disgusts me ( and you no doubt) on the regular.
    While i have to regurgitate these concepts tomorrow, i thought i would share a few that may make you regurgitate today! I certainly had a laugh!

    “share buybacks are used by firms to signal to the market that the shares are cheap, resulting in an appreciation in price” (which is regarded interchangeably as value) no mention of IV

    “capital structure has no effect on firm value”

    using CAPM to find ROE ( that just hurts) and all the rest from modigliani-miller, markowitz

    Anyway i think we can all be thankful for Roger and his growing following. I believe greater awareness of rational corporate activity can only benefit investors and companies, now and into the future.

    • Roger Montgomery
      :

      Hi Alex,

      It appears standards have fallen since I studied it. My first reaction was to wrap up a few copies of my book and send it to the deans and professors. The great advantage of course is in encouraging them to continue teaching efficient markets, WACC, CAPM and BETA.

    • Roger Montgomery
      :

      This is not the first time they have arguably sold too cheaply. Who knows what their motivation is? Its a question to put to them. Perhaps we should send them all a copy of Value.able.

      • Peter
        :

        Hi Roger,

        I concur with your comments. Seems like another example of the difference in the skills required to manage the operations of a business, manage its capital and value its worth. I may be wrong, but I suspect that there are quite a few companies out there with Boards and Executive management teams incapable of doing all three well. To make matters worse, some of these pay advisors huge sums of money to achieve the same ill conceived outcomes.

        Peter

  10. Michael
    :

    Hello, there is talk in previous posts of problems looming for the abks, My question is If the banking sector was to become in trouble, what sort of % of non-performing loans would cause their equity to be wiped out and our government bailing them out

    cheers Michael

    • Ashley Little
      :

      Hi Micheal,

      With a 1% return on assets the answer is “a very small number to make losses must a pretty big meltdown to cause a ballout.

      Very rough figures using WBC which has the highest MQR Loans

      loans $477B
      Profits 6.3B
      Equity 38B

      What scared the Banks so much during the GFC was not their loan book but their reliance on oveseas funding which became very hard to get in January 2009.

      This scared the banks much more than most people realise. Dont quote me on this but I understand our cashed up future fund helped the banks out during this period.

      Hence the big push for local deposits.

      My view for what i’st worth is a bailout of our banks like what happened overseas would only occur if we have another global meltdown and the overseas lenders dont just stop lending to our banks but demand their money back.

      Highly unlikely, But not impossible.

      • Roger Montgomery
        :

        Thanks Ashley,

        The other thing to remember is that with a large asset base and a very small amount of equity, you only need a very small problem with the assets to cause a very big headache with the equity.

  11. Nic Arena
    :

    Just had a look at some share prices for the first time in a couple of weeks. Interesting how this morning after bad news about Ireland it has effected forge’s share price (down 18 cents before midday) and a few other share prices. The interesting thing is how the news is not directly related to forge (only a month or so ago they announced a good increase in profits) only indirectly. Since starting this journey understanding businesses and how the share market works I have seen Mr Market rear his head often and how he is totally irrational. Thanks to roger and bloggers for their help in understanding and opening my eyes. I have a couple of questions if anyone can answer them I would be grateful
    1) Is there a site that sends an automatic email when there is news about a particular company. I am a member of commsec and I have to go to the announcement sections for each company I have in my portfolio. I can’t see any email alert system.
    2) Recently a few companies acquired other companies. In their announcement there is no information on price paid (ASX acquition price was included and therefore I could work out that singapore exchange was paying too much). How do we find out how much a company paid for another company if it is not in their announcements – would like to avoid companies that pay too much and therefore effect their ROE
    3) I have a high IV for Specialty Fashion Group Limited (approx $3.20) and current share price is at $1.25. They recently sold their female brand. How will this effect their IV (maybe my IV is too high). They get ridiculous ROEs each year (near and over 100 on many cases). The CEO said that the female brand was underperforming and they believe the money would be better spent elsewhere.
    Thanks

    • Roger Montgomery
      :

      Hi Nic,

      I am delighted to see the light bulb moments, such as the one you describe yourself having. As I have often been quoted as saying, there will always be opportunities to buy great businesses cheap because of Mr Market’s influence. I am now not sure of such a service as the one you describe, but I recall seeing it myself in the hands of someone I lunched with. Finally, with regard to SFH my valuation is a dollar lower but the issue is the quality of the company

      • John M
        :

        Hi Nic and Roger and everybody,

        You can register to get asx announcement notifications of asx listed companies at sharecafe. I get announcements emailed to me every day. Just a warning, if you register for too many companies (especially the banks) your inbox will be overflowing everyday.

        There is also a link to Roger Montgomery Insights on their site.

    • Matthew R
      :

      Wotnews – free and it does exactly what you are looking for

      It is from our friends at WTF, makes me think the thinkers in WTF understand a value investors needs are beyond just ROE

  12. Stuart
    :

    Andrew,

    I don’t necessarily disagree with your sentiments. For every reason I can think why Roger should consider the idea I can also think of a reason why he should not. But it doesn’t hurt to ask teh question and create some chatter.

    For what it’s worth, I only use Roger’s MQR’s as a trigger to do my own research. It by no means make an automatic buy in my mind. A number of Roger’s A1’s just don’t do it for me.

    I agree ther is great risk some people will blindly use the MQR’s as a buy signal without research. This will always happen in any form of investing I believe. The only positive to that is at least they will be A1 quality companies that the blind have bought into so their risk is hopefully reduced.

    On a personal basis I can say Roger has changed my life more than I could ever attempt to explain in this blog. If he was to cease doing all the work he does and sharing it with us, he will still have single handedly influenced my life more than any other.

    Roger, If I was you I probably would not share my full MQR’s either. But you have already shown yourself to be very generous so why not be a bit checky and ask.

    • Roger Montgomery
      :

      Thanks Stuart,

      Remember MQR of A1 means that its not going to blow up anytime soon. There is indeed more work to do once arriving at that conclusion. It goes a long way however to narrowing the universe. Boy oh boy does it save time.

  14. Ric
    :

    Hi

    I would guess contributing to the decline in the ERA share price is the influence of the Green’s in Fed government….and their PRESSURE to BAN uranium..

  15. Stuart
    :

    Roger,

    Have you thought any more about a subscription web site listing all your company ratings – A1 to C5’s? (not IV’s) Or do you intend to write a book on this also? Given you already do the work to rate every company on the ASX, you could generate a very significant income each year from the ratings list alone.
    You have equiped us with the method of calculating IV but to try to IV every company is a massive task as you well know. I work about 60 hrs per week and am still 20+ years off retirement so time is a stretch. I have looked at a number of subscription sites for value investing and most have subs of over $1,000 per year but most don’t have what I am after so they have not got my money yet.
    Only you know how many books you sold and how many more people wanted them. You would know from your blog how many followers you have and so you could do the sums. 2000 subscriptions, $500 per year….$1M…..not a bad start. You could have arange of subscriptions, current only, last three years, last five years, etc.
    As word of mouth spreads about Value.Able principles and results teh level of interest is sure to rise. I am still a raw beginner and have missed a number of opportunities but even so, my investment returns range from 28 to 86% in businesses purchased since May 2010. I am sure you and many other bloggers are doing even better than this.

    I would be interested in other bloggers thoughts on a subscription site to your company ratings.

    Keep up the good work and thank you for taking the time to help educate so many.

    Stuart

    • Andrew
      :

      I can see what you mean and think that it would be popular, however Roger, don’t do it. You teach us Roger about competitive advantages, your MQR’s and the details you use to analyse and come up with your rankings and IV’s are your competitive advantage. So protect it for all its worth.

      Also, i think the danger here is that people would completley lose the point of value.able. Instead of doing it themselves and becoming better investors they will simply just ride on Rogers coat tails and buy whatever company he lists as an A1’s and below his intrinsic values. May as well just open up a managed fund,

      Instead of getting Roger to fish for us i think it is important that we use the skills Value.Able teach us (all of them and not just the IV calc) and expand on that to learn our own way to fish which is successful for us.

      Roger is a great guide and i thank him immensley for all the knowledge he has passed on through his book and blog but the final decision on what is and not a good investment for ourselves comes down purely to us.

      • Andrew
        :

        Also, use the MQR’s as a guide if you wish but like he said, this can change at any time and he doesn’t need to inform us at all and we are lucky he is willing to share as much info as he does. But it is important that you make the decisions based on what you think the quality is.

        For example, Webjet was listed as an A1 by Roger but doesn’t reach the equivalent level of diamond class in mine. I might find some companies in Roger’s list of A1’s which i never knew before and that might trigger me to have a bit of a peek at them but that is the start rather than the end of the process.

      • Roger Montgomery
        :

        In the process of doing some audit work on the A1s. Thus far it appears blindly buying those that ranked as A1 last September and trading at a discount to my estimate of intrinsic value and holding until today, returned 103%. That was with no qualitative overlays. Of course my audit may unearth a much lower number. Not advice, seek and take personal financial advice.

      • Andrew
        :

        Yeah it sure would, and i think you would have a pretty good chance of doing it. Especially if you keep up appearences on Sky. The Roger Montgomery Value.Able brand is no doubt growing and developing steam.

  16. Mark H
    :

    Hi Matt,

    I have 2010 company cashflow for WBC of -$33.8bn, with operating cash ($468m) significantly below ’09.

    Am close to your debt figure and have divi’s paid of $2.8bn. My figures are from p128 of the latest annual report.

    Cheers, Mark H

  17. Brian
    :

    Hi Roger,
    Not sure if this is the right place to post a request, but I was wondering if you are planning to comment on the forthcoming offer for CountPlus. (I see you can now download a prospectus.) I imagine a few here are holders of Count Financial.
    Regards,
    Brian.

  18. Andrew
    :

    Another thought,

    I will continue to monitor and buy CBA shares when they become affordable. And i actually wouldn’t mind another crash which gives me another chance to buy even more CBA shares at $26.00.

    The big 4 are great businesses and i echo the thoughts of CBA probably being the benchmark,

    I do think a lot of people having a go at the banks might not have truly understood what happened during the GFC.

    I was in the UK when lehman bro’s collapsed and Northern Rock (is that the right bank) went into trouble and the Royal bank of Scotland announced a huge write down and looked in a bad way. I remember seeing on the news people stressed lining up outside their local bank trying to withdraw all their money because they were worried they would lose it all.

    As we have 4 great banks, we did not experience this and thankfully so. I do think this however has led to the majority of Australians taking the banks for granted. We should be thankful that we have 4 strong institutions holding up the economy.

    i remember during the GFC my mum was trying tell me to sell my CBA shares, i told her i will do quite the opposite and buy more, she said but what if it collapses. I said “it won’t collapse, and if it does then the Australian Economy is going so bad that we don’t need to worry about money as it will probably be all gone”. Not neccessarily correct but their is an element of truth in that comment.

    My point basically being, that firstly i don’t expect much to change especially with the current lot in canberra being far more eager to show how they are smarter then the others. Secondly, the banks are strong and we should be thankful they are as it is because of these strengths we didn’t have to worry like our friends in Europe and America.

    I think they are great buisinesses to own and will continue to do so for a long time whilst they still have a competitive advantage.

    • Rob S
      :

      The reason Australia survived the GFC is not entirely due to the greatness of our 4 institutions, rather, it is the support these institutions have received from the government.

      Since the late 1990’s, we have seen a quadripling in the level of household debt as a ratio of GDP. This has been due to the residential housing market. There have been a few drivers, including the numerous introductions and doublings of the first home buyers grant/bonus, the availiability of relatively low cost credit, and the tax incentives of negative gearing. The resulting boom in house prices has seen the majority of bank lending diverted from funding productive businesses to the purchase of depreciating assets from one-another with increasing levels of leverage. The wealth effect of house price inflation also had a positive effect on consumer sentiment – When you see the value of your house double every 7-10 years, there’s the chance you might want to access some of that ‘wealth’ to buy a new TV, ipod, car, or hell, buy another house with only 10% down…

      When the sub-prime mortgage crisis hit in the US, this caused the beginning of a collapse in this Ponzi-financed debt structure globally. The US is slowly de-leveraging and most of the rest of the world’s economic woes have arisen from this peak-debt phenomenon. In 07-08 house prices started to decline across Australia, only to be recovered by the first home owners bonus stimulus. The government stimulus response of giving money to consumers rather than banks (as the US attempted) was also very successful in stimulating spending.

      The reason our economy appears to be doing so well is that we haven’t yet started the deleverage process. , but the Ponzi scheme cannot continue indefinitely. When people start to realise that house prices don’t necessarily have to go up, and rapid capital gains become a thing of the past, then we’ll start to see the correction. The start is high volumes of new listings and low volume of sales as there is still a mis-match in expectations between buyers and sellers – this can take a good year or two to correct, so we’ll have time to see it coming as Roger says.

      Our mortgage recording system and RMBS market are not riddled with the systematic faults that have brought the US economy to it’s knees, so the fallout might not be as severe for our banks. Bargains might be presented then. It will hurt the real economy however as we shift from consumption to saving and debt-deleveraging. The resource boom we are seeing might help us, as long as we don’t use the proceeds to buy existing assets off each other.

      In the short term inflation might be seen as a risk (real inflationary pressures higher than CPI, mining making us all rich etc), but I think there is a greater risk of deflationary pressures in the next few years (Prices dropping leading to reduced profits, leading to reduced wages…).

      On a completely different note, has anyone looked at UXC?

      They run a business similar to SMX and OKN (A1 and A2’s respectively), but have a greater market share, and 30% of business is with government agencies. UXC posted a marginal loss last year due to discontinued operations in one wing of the business (due to the winding down of the bats-in-roofs and solar panel rebate by the federal government), but the other two wings of the business have ~19% ROE. Overall cashflow was still positive in the financial year too.

      Management are looking to realise this value by selling or spinning off the less profitable Field operations unit of the business. Using Roger’s work, the value of the other parts of the company (business solutions and ICT) comes to about $305 million (which conincidentally is what management reckon it’s worth too!), and the Field unit has net assets of about 60 million, which would likely be what it goes for. Current market cap is ~150 million, presenting a 50-60% margin of safety (depending on what you value the Field unit as).

      Regrettably, any corporate restructurings are yet to be announced and the stock is rather illiquid, so could prove to be a profit-less value trap. Nevertheless, I found it interesting that Roger’s calculations can be used to find hidden value within a company, not just for companies as a whole.

      Cheers,
      Rob
      ^^^^All opinions. Seek professional advice.

      • Roger Montgomery
        :

        Hi Rob,

        An excellent post and thank you for taking the time to prepare such a high quality contribution. Please keep posting, if readers don’t realise how value.able this is right now, they will soon enough.

  19. Andrew
    :

    Hi All,

    First off the disclaimer… The author of this comment has his largest holding in that “evil, greedy” company known as the Commonwealth Bank Of Austrlia.

    Rogers blog mentions economies of scale, one thought i have had during the whole Banking Season witchhunt is could all this noise being made about the banks actually result in regulations that further enforce the big 4’s strengths and there for less competition

    The Big 4 all have the economies of scale going for them and have a large deposit base. An increase in the competition can come from two area’s.

    1-The smaller banks (adelaide, bendigo etc) and building societieis

    2-International Banking companies previously reluctant to do business in australia

    Which type of increase in competition in the banking sector do the people and politicians want to have.

    The only way i can see the existing competitors (smaller banks and building societies) to catch up to the big 4 is to regulate and make it harder for the big 4 to do business and place guidelines relating specifically to how they do business and not the others or for the government to almost subsidise the smaller operations.

    If they want to encourage international banking companies to set up shop in Australia then i feel it will be those same smaller institutions that will be harmed instead of the big 4. I don’t think those smaller institutions already established would have the power and economies of scale working for them to help survive any type of price war in the industry.

    i wonder if the Big 4 come out of all of this with their competitive advantages entrenched further which political party will put their hands up and say it was all down to our pressure on the banks.

  21. Matt
    :

    Hi,

    Looking at WBC’s cashflow, I’m doubting the numbers I have. Cash of $1.2b – $19b borrowings (debt issues) – $1b share capital + $3.7b divi’s paid = -$15.1b.

    Is this reasonable?

    thanks, Matt

  22. Henry
    :

    Hi Roger,
    Is it a bit risky to invest in banks now considering the housing bubble that must bust ? Once, the bubble bust, how low can banks IV fall ? Please post your thought on housing bubble bust and banks IV relation ?

    • Roger Montgomery
      :

      Hi Henry,

      One of the most profitable lessons for me has been learning to invest on the basis of what is known and avoiding the temptation to jump at unkown shadows. With regards to this ‘inevitable’ housing crash, I don’t dismiss the possibility but I firmly believe that because of illiquidity, it would (if it were to happen) look like a slow motion train wreck rather than the stock market style correction (which I am told has commenced by my crystal ball gazing friends) and there would be plenty of time to respond.

  23. Ric
    :

    Hi all. There’s a lot of really smart people shorting the banks (particularly CBA) because they consider Aus housing as way overpriced and expect further defaults. Everything they are saying makes sense…Poor return, easy credit, rising interest rates, reduced tax incentives (margins changing), ageing pop, reduced imigration, fudged numbers (housing shortage)….. Just want everyone to be vigilant about what shares they are buying. If this housing correction occurs what affect will it have on not only the banks but discretionary shares too…Indeed the whole economy…..

    Just forwarding a sumary of stuff I’ve been reading and wanted to pass it on to this very helpful community……Thanks.

    • Ashley Little
      :

      Hi Ric,

      Thanks for that,

      Good on those shorter, that what I say

      Hope they drive the price down so that we can all but quality businesses at a big discount.

  24. Ray Walsh
    :

    Hi Roger,

    When you calculate forecasted equity as per formula below shouldn’t the tax be taken into account before adding to previous equity per share?
    Forecast Year Equity Per Share = Previous Year Equity per share + Forecast Earnings per share – Forecast dividends per share + new share capital(per share) – buybacks(per share)

  25. John M
    :

    Gday Roger and fellow Value.able students/graduates,

    A little bit of scuttlebutt with NAB. Roger, this is John from the Charlestown RBS Morgans talk. I went to the local shopping centre across the road from the Bowling Club this morning and while I was waiting for my wife to finish some Christmas shopping, I had a chat to an NAB banking representative. They have a kiosk (not a branch – so low cost, with two staff with laptops) and the staff are there to recruit new bank deposits. The account they were selling has no fees, yes you are reading correctly, but very little interest. The real selling point for the account is if you make a deposit by December 13, they will deposit $50 into your account. For a general purpose account, this is pretty good, my current account is always charging fees. I had never considered a bank account with them before, but they were standing right in the middle of the main food court between Woolies and Coles, and they were approaching everyone as people went to get their groceries, with the flyer in hand and promise of an offer too good to refuse. Maybe they will have a return to a higher MQR in the future if they don’t try any crazy overpriced purchases. I couldn’t help but mention the NAB company track record to the banker, and he assures me they have a whole new culture.

    I would also like to talk about your Valueline column in Alan Kohler’s Eureka report. If everyone isn’t already aware, this is a paid subscription online service. The paid part used to turn me off, but I recently started subscribing, and now I am annoyed with myself I didn’t start earlier, I have literally cost myself in missed investment opportunities. For example, on August 18, you introduced Matrix C&E(MCE) in a Valueline commentary, the chart had MCE at $3.92. MCE closed at $5.15 on Friday, so I work out this to be a 31% gain in 3 months (or 120% return on an annualised basis). If someone had invested only a small amount in that one stock alone, the subscription would have paid for itself. I am guessing you know Alan Kohler very well Roger, so you would also relate when I say I have also missed out on Alan’s unique sense of humour. As everyone seems to say, seek personal professional advice first.

    Hope you all have a great weekend,

    John M

    • John M
      :

      G’day again,

      I am interested in the inflation hedging properties of commodities and the depletory effect of holding cash in banks with inflation obviously higher than the headline rates.

      I think you have mentioned a commodity-centredconversation with Jim Rogers and also the idea that you would prefer direct commodity exposure than have the inherent risks that can be involved in holding stocks with commodity exposure.

      How do you invest in commodities? Is it better just to stick to investing in quality companies using Value.able criteria?

      Obviously MCE is a play on an exposure to oil. Was this an intentional oil commodity play, or purely an A1 MQR company at a discount to IV or a deliberate mixture of both.

      Could you comment on your views on commodities and the role of them in hedging against inflation in the long term?

      Thanks for your company,

      John M

      • Ashley Little
        :

        Hi John,

        Thanks for your thoughts

        You may not believe this but the daily cash rate of a CMT or CMA has actually beaten inflation over the long run. That is to say if you are in a tax free environment and don’t need the money then cash can be a hedge against inflation.

        Like you I am concerned about the prospects of inflation given the 21 century’s version of the printing press (quantitative easing) is being used around the world to prevent deflation.

        Combine this with everyone’s race to get their currencies lower makes interesting viewing. The western worlds needs to tread a very fine line.

        All that said the current prices of commodities probably already have an element of inflation expectations in them.

        I note that commodities in real terms over the long run have actually been in decline.

        People may not believe me on this but think how we got coal out of the ground 200 years ago. . How did we harvest wheat? . Overtime we have become more efficient at harvesting commodities and despite the fact that demand has risen with rising world population the real inflation adjusted prices have fallen.

        This will continue.

        So hiding in commodities as an inflation hedge may not be the best use of capital.

        For what it’s worth I believe that buying really really good businesses with little or no debt and high ROE will outperform most investments over the long run.

        I will stick to these

      • Ashley Little
        :

        Hi John

        Oil may be different though.

        That said I hate it when i hear this time it’s different

  26. Leon
    :

    Hi Roger,

    I was wondering if you could set up one of those intrinsic valuation tasks again like the one you did a while ago.

  27. Steve I
    :

    Roger,

    I don’t see much upside in the banks. They are all very close to IV and don’t appear to have much potential from here.

    The main problem is that we have had an explosion in credit growth over the past decade and this is very unlikely to be able to be repeated and this will hamper revenue growth.

    On the other front, the banks cannot increase their margins very far without hitting regulatory/political risk. I guess this is why they have been looking into beefing up their business banking arms.

    In my view, we probably have hit a ceiling in private debt levels in this country. If we experience any price instability in the housing market the banks would be likely to undergo a material amount of stress. In addition, if interest rates continue to climb (I think they will) then bad and doubtful debts could come back and hit earnings again.

    Given that they currently appear to be fully priced and have significant downside risks, its an area that I personally would rather steer clear of for the time being.

  28. Kathy
    :

    Great article yet again Roger, if only most Aussies understood that the banks are only getting 1%. I’m getting rather tired of hearing people whinge about interest rates…

  29. fred
    :

    Hi room

    I am sure there are guns that understand rare earth type company’s but it’s not me . ERA has come down in price a lot and may seem cheap but this black duck believe’s it’s still way over priced and it’s in the wrong sector. Seek professional advice of course! Roger explain’s that he only buys into company’s that he understand’s and rare earth isn’t easy to understand for me.

    See ya

    • Simon
      :

      Excellent Fred!
      Rare Earths are in fact one of the biggest bear traps that investors (i.e speculators) are digging for themselves only to fill them up with $$$ and then later walk away, without a bear or any rare earth metals. There is too much noise going around over rare earths, even for me as a chemist and teacher that has followed this sector since ’98 I still tread a cautious path in investing in companies that aren’t >20% ROE. As for investing in companies that you understand, I sincerely hope that you spend the time to research areas like coal seam gas, ceramic fuel cells, vertical integrated miners of dolomite/magnesium/uranium etc. As these companies will be on the wish list of Indian and Chinese companies M&A activity for the new decade.

      • Roger Montgomery
        :

        Hi Simon,

        Agree. Watch Uranium prices over coming years. There are some ETFs with exposure to Canadian producers (Australia is has the world’s largest desposits but politically it will take some time to see it above ground. I will write about this in a future post with more detail.

      • sapporosteve
        :

        I have read a few posts that appear to downplay investments in Rare Earths (RE). First up, I hold Lynas (bought at a range of 26 to 50 cents) thereby delivering a profit of between 200 and 400 percent – this is a decent margin of safety if I should have reason to worry. I also hold Arafura which is also up considerably. I have held both them since April 2009. I would like to explain why I bought them.

        After a reasonable level of study, which I include reading trade journals and passages in books such as “Buying at the Point of Maximum Pessimism” (by Templeton’s firm) which has a passage on RE potential, determining RE future supply and demand levels, seeking alternatives to RE in manufacturing taking note that these minerals are a necessary requirement for the green revolution and are also critical (sadly) in weapons development giving them a strategic value in which no government will will without future supply security. China does supply most of the materials and so if you cant buy those companies then it would seem a low risk to buy the alternatives.

        A major issue is that China has been selling these RE cheaply so as to corner the market. Now they have they are the price makers not the price takers. Therefore, Australian companies can be somewhat of a free rider thanks to China’s monopoly.

        One would expect RE prices to rise in the future as global growth picks up, supply tightens and the green revolution goes mainstream.

        Buffett has said that he first looks at the company and then the price. Look at Lynas’s earnings expectation for 2011, 2012 and 2013. I would be happy to receive any alternative and considered assessments as to why RE are not a good investment.

        Both Lynas and Arafura have high quality deposits of RE in the ground. Its not the case of a miner standing next to a hole. The resources are there, quantified to industry standards.The reason why I bought them was that there was going to be a necessity to mine them for the global manufacturing industry – just like those who believe that the future is the same for Australian uranium.

        But uranium, ceramic fuel cells, coal seam gas all have alternatives. Wind, solar geothermal appear rather more speculative than RE. Ironically all these technologies cant happen without RE.

        I have done my research so I do not need or be influenced by the current “noise” surrounding RE in mainstream media, but this also does not make them wrong. An alternative view would be that the mainstream have just woken up to what is actually a fundamental supply and demand issue and coupled with the strategic nature a very serious one indeed. Would the mainstream media be incorrect if in 3 or 5 years they suddenly determined that uranium was “mispriced”. As value investors don’t we hope for the mainstream to realise the fundamentals and drive the price back toward intrinsic value?

        As Roger says differences of opinion is what makes the market.

        regards
        Steve

  30. Damian
    :

    Hi Roger,

    Just finished reading your book, many thanks. Really liked the tables in Chapter 11, showing how the dividend payout ratio has a big effect on the value. It seems from your references that the 1981 Berkshire Hathaway letter was a critical one for understanding Buffett. I wonder why he revealed so much in this particular letter?

    Also liked the simple example where you showed the effect on the balance sheet of capital raising, very clear and easy to understand.

    Can you just clarify something for me from your book.

    You mention not to look at price/book ratios.

    Do you mean “in isolation”?

    For example, with FWD, if you assume it pays out all its profits as dividends, ROE of 25 percent and required return of 10 percent, doesn’t comparing 2.5 to price/book give you an indication of the value, if my understanding is correct?

    • Roger Montgomery
      :

      Hi Damian,

      Thanks for the feedback and encouragement. The issue with price to book is not that it can be used as a proxy for value in some situations but that multiples generally – like all rules of thumb – are not flexible enough to be applied to all.

    • Ashley Little
      :

      Hi Damian,

      Buffet gives lots of pointers in all his letters to shareholders and the Berkshire Hathaway owners manual.

      I would recommend all Investors read them.

      BTW he is a very funny guy as well

  31. Craig M
    :

    Hi Roger, Mr Little and any would be bank buyers,

    looking at the table one notices that non of the bank is at a discount to IV and the expected change is meagre at best. Even considering Rogers Island argument they just aren’t good value and there are better opportunities at the moment.
    Ashley is correct, the time to pick the banks up are when the economy is in taters and when they are very close if not at a discount to NTA. Look at what was available in late ’08 ANZ was briefly at a slight discount to NTA.
    A strategy I used during the 90s with success was to purchase bank shares when dividend yields were a couple of percentage points above the mortgage rate. Basically the bank was paying you to buy it’s shares.
    Not advocating that now as I now know how to value businesses and well it’s alot safer investing this way. Buy with a margin of safety, the banks don’t have one.

  32. Simon
    :

    Came across this er um Value.able instructional report and thought other Valueable graduates would get a laugh out of it
    NAME WITHHELD. What did you think Roger, of this um analytical approach ?

    • Roger Montgomery
      :

      Thanks for sending it through Simon. Coke gets lots of imitators too but nothing tastes as good. I am flattered by the sudden explosion of intrinsic value experts. The more people thinking about it the better.

  33. Luke
    :

    Banks can also increase their profits by reducing expenses, not just further lending and charges.

    Regards
    Luke

  34. Chris
    :

    And too many people fail to remember that their (retail) super funds likely hold a massive tranche of bank shares (in all four, I might guess), so that they indirectly get some of this profit back – do they complain about that ? No (in more than one sense of the word – because they’re usually oblivious that they even hold any or what their super is doing, or if it made any money last year). They’re too focused on the negatives.

    …but oh no, it’s too popular (and populist) to pander to the whingeing and moaning of some folks – mum and dad mortgage holders – who are perhaps too highly leveraged or disorganised / lazy to get the best financial deal for themselves.

    Guess what ? I’m a first homebuyer / mortgage holder as well, but I don’t moan and complain about it, I do something about it and also live within my means, and if you’re hurting, chances are everyone else is too.

    The only people who have a REAL barrow to push right now are SMEs (particularly retailers), who really ARE “doing it tough” with the restricted flow of debt financing. No, I’m not one of them, but I do empathise with their pain, because for the most part, they’re trying to better themselves financially by running their own businesses, instead of racking up consumer debt needlessly like most people do.

  35. Ray
    :

    I will declare my hand, I do own ANZ. However, I do not think that banks are a good investment, and certainly not at their index weightings.

    Let us be honest, Australian mortgages are what drives bank profits, mainly due to our regulatory system – banks can lend far more on a home mortgage for each dollar of capital than they can to business for each dollar of capital. This creates a huge incentive to loan for home mortgages rather than business loans (a higher ROE).

    This is a nice arrangement as long as home prices continue to rise. But what if they don’t? What if they decline? Remember, gearing works in both directions, and slim margins leave little room for changes.

    This is the conundrum faced by the USA. Take a really good look at the causes of the GFC. What happened?

    Debt is not usually a good thing. Every Value.Able graduate knows that. How does that reflect on the value of our banks?

    Which bank? Well, I would invest elsewhere. Mostly.

  36. Ben
    :

    Great article. As a Westpac employee myself I can assure you Gail runs a mean keen and mighty profitable machine. WBC sure is an A1 from what I observe at the coalface.

      • Ben
        :

        I will Roger. Mind you I am sure the other 35000+ Employees would like to say hi to her on a 1-to-1 basis I am sure. She is now a very powerful woman and seeing her is a bit like visiting royalty. You have to have nerves of steel as you never know what she is thinking, usually the response she is going to give to your next question when you are only still asking the current one. She is a very quick thinker and I use to see her work when we were both at St George many years ago, needless to say she is a great CEO in my eyes..and worth every $ they pay her.

  38. Tony Carson
    :

    Hi Roger
    A 1% return on those assets sure puts those super profits into perspective. Interesting as usual Roger

  39. Ashley Little
    :

    Hi Roger and fellow ROE investors.

    For what it’s worth I think the time to buy the banks is when the economy is a mess. The Banks usually fall close to their book value or in the case of the early 90’s below that.
    Mr Market projects the current economic conditions to continue forever but we all know that tough economic conditions finish and a boom begins.
    In late 2008 and early 2009 (and especially on the early 1990’s) the banks were ridiculously cheap. However they went from very cheap to expensive in the blink of an eye.
    I know with great certainty that Australia will have tough economic times in the future but I certainly don’t know when.
    I will keep my powder dry until then when I know I can buy 2 or 3 of the best banks in the world at a significant discount to their true worth.
    This may be a long time but in the meantime there are plenty of other things to keep my eye on

    BTW if someone put a gun to my head and said you must buy a Bank it would be CBA without a doubt.

    No adice guys BTW

    • Ashley Little
      :

      BTW guys

      I forgot to add that due to the nature of their businesses the banks will make losses and big ones at some time in the future. I just dont know when.

      How do I know this.

      When you hear someone say it’s different this time………………… RUN

      It never is

      • Ashley Little
        :

        Hi Roger,

        No the Banks have made hugh losses from time to time in the past.

        They will make huge losses at some point in the future.

        Nothing is different

        All we need in a good old fashion recession

        Dont know when its coming but it will. Maybe next year maybe next dedade.

      • Lloyd Taylor
        :

        Ashley,

        You said “For what it’s worth I think the time to buy the banks is when the economy is a mess.”

        Truer words have never been spoken.

        For the doubters: Just look at the share price performance of any of the banks over the last five years compared to the last two year period and you’ll understand the deep truth of this statement!

        Buy low, sell high!

        And this is consistent with Roger’s investment philosophy… a big margin of safety is required when the ROA is 1% and the outfit is leveraged to the hilt!

        Regards
        Lloyd

      • Lloyd Taylor
        :

        Ps to my previous post – a 1% ROA plus a soiled diaper requires an even bigger than usual margin of safety!

  40. Fred Matthews
    :

    Hi Roger,

    Would love to hear your view on ERA (in a previous post you said we would hear more from you about ERA at some point). It seems below IV (I get an IV of 19.30-20.05) and only 3 months earlier had an IV of $24 approx. There are alot of IV posted that are under mine. What has made this company plummet dramatically (is it just on the nose?) besides the cutting of uranium and profit downgrade (Maybe it is just this). This company had an ROE of approx 30% for the past 2 years, little or no debt, they made 49 cents on every dollar of sales last year, NPAT has increased the last 3 years (23-24% last year), ret earnings 3 times common stock, total current assets 3 times current liabilities and cashflow is good. Seems an A1 at a good price. Some guidance would be good on this company to avoid a mistake. My portfolio is looking good (bought fge at $3.70, Decmil at $1.90 and Oroton at $7.10) and I now know how to look at a company – thanks heaps. Would love to avoid a mistake of purchasing ERA at $16ish now $12.

    • Ken Milhinch
      :

      Fred,

      My IV for 2010 was $15.39 and for 2011 it is $4.64, due to what I estimate to be a 50% reduction in NPAT.(I use 14% RR for miners to partly compensate for the risks attached)
      Reading their half year result (NPAT down 86%) and the latest update which says that they will have to purchase about 1,100 tonnes of uranium and then resell it to meet their 5,000 tonne contractual obligations, I would be very concerned.

    • Paul R
      :

      Hi Fred

      It’s worth reading the half-year report to get some insight into ERA’s problems. NPAT was down 82% to 12cps! The report mentions the impact of rainfall on mining operations, the reduction in the quality of uranium mined, high AUD, increased maintenance costs for aging equipment etc. I also thought that the traditional owners of Jabiluka have refused to allow Rio to mine it (but didn’t pay attention to the news details). You should also ask if ERA is an enduring asset. As it is a mining operation, it really is wasting away (like all mines) and a quick glance at the Ranger mine’s resources suggest it has about 10 years of mining ahead of it. What will it and the shares be worth after 10 years? Without more proven reserves, zero would be my starting point. Since Rio owns 68% of ERA, a better approach might be to look at the diversified miner instead and not have a big exposure to ERA’s problems.

  41. Tyler
    :

    Buffet states he does not see a economies of scale beyond a certain point for banks, and has suggested ROA was an important measure.

  42. Scott T
    :

    Great Article Roger,

    CBA has long been the best run and most profitable bank by my standards.

    And good afternoon to you Mr. Little.

    All the best

    Scott T

  43. Lloyd Taylor
    :

    Roger,

    Thanks for a thought provoking post. But I just cannot get past Which Bank? The UNPOPULAR Bank! Presently, its leadership and reputation is about as friendly and respected as a soiled diaper. In the long run, reputation and perceptions of reputation are significant determinants of bank performance and I think CBA may have soiled its nest in this regard.

    Its certainly dangerous to ignore populist sentiment when you serve the public.

    Respectfully yours
    Lloyd

    • Thomas
      :

      Coming from a macroeconomics background, the media hype about interest rates hikes matches the short run/long run theories of monetary policy. in the short run monetary contraction does affect the economy’s output level, but in the long run the economy’s output level is fixed. prices will eventually account for the scarcity of money and will decrease accordingly. The negative publicity about the CBA putting their rates higher than the RBA’s will be short term (just like all the other times the big 4 increased them before the GFC when mortgages were hitting 9%). It is probably the reason why the big 4 still have 90%+ market share.

      Thomas

      • Roger Montgomery
        :

        Thanks for that link Craig. I have no problem at all with the idea that interest rates go up and down. The argument that their funding environment is tough and they “have” o increase rates by as much as they did however is disingenuous in the presence of multibillion dollar profits and double-digit increases.

      • Scott
        :

        Although it is not as free as 6 months ago I am still able to obtain a mortgage from a huge and well respected overseas based bank for a property purchase in Australia. The bank in question does have branches here but I am talking about overseas finance. The rate is a small fraction of the rate here in Australia and although I know the local banks are not largely funded from domestic sources they continue to quote the foreign funding excuse.

        I do not buy it, Australian including most people in government and business are naive in terms of the international environment and many who understand this use it to their advantage. You can tell a lot of lies and the naive are never going to understand enough to truly understand the question, never mind making a valid judgement on the truth of the answer.

    • Andrew
      :

      Everyone one fo the Big 4 is the unpopular one at some stage. Just like Craig Said Westpac was the last one. This will not always be the case and will more than likely last until the next RBA meeting that keeps rates on hold.Then it will be a different bank that raises above the RBA and then it will be their turn.

      I don’t think it will have any impact on the long term future of these companies and COULD result in a gfew good buying opportunities in the short term.

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