Your key to the best bank stock
You may not have heard of Return on Incremental Equity but it determines which bank is the best value. Read Roger’s article at www.eurekareport.com.au.
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.
marina
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hello, rob what do you think of NAB shares ie do you think they will be stable enough to ride out the new lenders coming onto the market?
Rici Rici
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A further comment, i was going back through your past threads, and picked up again on
‘Which Bank do you own?’.
I was looking through the estimated ROE ranges.
Again i take a bit of a ‘holisticview’, but if the history of capitalism teaches us one thing, its that natural competition will always focus on the easiest route to profit.
Hence over time new entrants will try to take market share away from high margin businesses, and its the barriers to entry that come into play at this point in time (the stronger the barriers the more difficult it is for new entrants).
In the banking sector one often talks about the natural oligopolistic situation of the big 4. And i partially agree on this point but not totally.
If one looks at the pre- GFC environment, one will notice that bank margins (net interest spread and net interest margin) within the big 4 declined over a 10 year basis (but was made up for by an increase in ‘non-interest income, ie other forms of revenue such as bank charges, funds management etc).
Now in the post GFC environment the big 4 banks have come to the forefront again with their dominance in traditional lending.
But i cant help but think to myself that this is a cyclical situation, rather than a structural reversion.
Over time as things move to some form of normalicy (and they will, history has shown this time after time), competition in the lending market will intensify and any excess ‘margin fat’ will be competed away again.
This time around though, it may not be so easy to just increase the ‘non interest income’ at least not to the same degree (eg look at CBA its non-interest income rose from $2.4 billion in 2000 to $7 billion in 2009).
Maybe i am reading too much into things, but i am constantly trying to focus on providing myself with that margin of safety.
Sometimes that margin of safety comes from factoring in issues that the Analysts (who are suffering from near term data bias) have not yet built into their valuation models.
ie something similar to the period just before the opportunity to ‘buy the glitch’ as per Kennith Fischer’s works.
Roger Montgomery
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Hi again Rici, Rici,
What a fantastic post! There are so many avenues of thought you have opened up – comptetion, the distribution of prices, the business cycle et.al. The new status quo may be maintained until the next shake up rather than in relation to the business cycle.
Rici Rici
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Thanks Roger for another insightful topic thread.
I have spent alot of time reflecting on the main premise of your investment thesis being ROE.
And this leads me to the understanding that movements in intrisic value are primarily determined by
(a) the ROE in itself (as this is then discounted by the RR); and
(b) the future movement in the ROE
(assuming other factors constant, such as shares on issue).
Building on this, the greatest efford needs to be directed at (b)
For the big 4 banks this poses an interesting question.
You have highlighted that you ‘like’ NAB the least because of its 10 year lower historical ROE compared to the rest.
But your thesis relied on the data from 2000-2009.
What about the period from 1987-1997?
From memory NAB was the star performer during this period, whilst ANZ &WBC nearly went broke.
Therefore i reflect on which is the best decision to make.
YES CBA has the highest ROE, but this is also required to sustain the higher share price. If CBA incurs some future misfortune, the subsequent lowering of ROE will have a more magnified effect on intrinsic value because of the higher base.
Conversely for NAB, if it can increase its ROE to approach its peers the, this will have a more magnified upwards effect on intrinsic value (since it is comming from a low base).
For myself i hold shares in CBA,WBC and NAB. (CBA and WBC during the debt of the GFC, NAB on the recent market pullback)
I dont hold shares in ANZ because i am uncomfortable with ANZ trying to become an Asia Pacific Regional bank. This creates a whole new set of risk factors, and Australian companies generally do not have a good track record of international expansion, except where they offer a unique product (such as CSL, COH)
Roger Montgomery
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Hi Rici Rici,
Its a really good thought. First, it is the valuation models of the 50’s and 60’s that first examined ROE so I give all credit to the pioneers then. Second, I see your point about choosing the relevant window. I do believe that the changes to the leader in banking should be expected but like Benoit Mandlebrot, I don’t think the change follows anything like a normal distribution. By that I mean, the changes cannot be forecast. It is violent events like the GFC reducing non bank lending to a shadow of its former self, that changes the status quo in Australian Banking. CBA and Westpac now dominate. It may need hubris and another GFC to change things again.
Steven
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Hi Roger,
Enjoy your blog and also your contribution on Sky Business Chanel.
Can you give some insight as to how you go about collating the information that is used in your determination of intrinsic value? i.e. is it derived from the annual report, broker estimates or a combination of various sources?
Do you use spreadsheets, back of the envelope or other means to process the information?
Kind regards
Roger Montgomery
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Hi Steven,
The best source of course is the annual report and the announcements made by the company between the fully year and half year. Forecasts are provided either by the companies themselves or analysts and when you practice enough you can do approximate valuations in your head. Just as you’re able to recall that 150+150 = 300 so you can with 10/20 = 0.5 or 20/10 = 2