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Onwards and upwards for financials, resources: Nikko AM

Glenn Freeman  |  09 Feb 2018Text size  Decrease  Increase  |  
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Amid uncertain times for Australia's financial services and resources sectors--two of the largest segments of the ASX by capitalisation--Nikko Asset Management's head of Australian equities remains upbeat.

"Banks look very cheap on a relative basis," says Nikko's Brad Potter. He points to the aggregate PE ratios for banks versus industrials, which currently displays "one of the largest gaps we have seen," with banks trading at a 30 to 40 per cent discount. They traditionally trade at a discount of between 15 to 20 per cent.

While the spectre of the Royal Commission into financial services has many investors spooked, Potter says Nikko's view is that a lot of those headwinds have already dissipated.

This concurs with the views of Morningstar's senior banks analyst, David Ellis, with each of the "big four" trading at a discount to their respective fair value estimates (FVE)--Westpac (ASX: WBC) by as much as 10 per cent, tipping it into the Accumulate zone.

According to Nikko's Potter, in addition to concerns around the Royal Commission, "capital has been a big issue for a number of years, but the banks now are capitalised at a level we really feel comfortable with".

"ANZ Bank (ASX: ANZ) in particular has excess capital, currently doing a buyback, and it wouldn't surprise me if there are other buybacks announced in their results in May," he says.

Potter also highlights a number of structural changes ANZ and National Australia Bank (ASX: NAB) are making in reducing their costs. NAB sold 80 per cent of its life insurance operations in October 2016, and ANZ is divesting assets in Asia and refocusing on its local banking business.

"They're making real cuts, which is needed--these are really very bloated organisations that need to resize their businesses in a way that's appropriate to the way people want to do banking, and to utilise the technology that's coming though," Potter says.

He expects Westpac and Commonwealth Bank will soon follow that path too, which "presents very big opportunities for banks".

China confounds expectations

In resources, another sector that comprises a large proportion of the local market, Potter says it "traditionally does very well during a hyper-cycle, particularly during synchronous global growth".

"But the change this time around is the extent of the impact that China has on a number of those commodities."

He refers to a situation where many investors--professional and individuals alike, himself included--were wrong-footed last year by anticipating an iron ore price drop amid expectations of an oversupply.

"And in fact, we were in oversupply this year, but what we didn't foresee is some policy changes within China," Potter says.

This included regulations requiring steel mills to use higher-grade iron ore, and environmental measures, leading to a "bifurcation of the iron ore price".

"In aggregate, iron ore was in surplus, but Chinese demand was in high-grade iron ore, so we saw this spread between high and low-grade prices," Potter says.

"There is a question of whether this is structural or cyclical. I lean towards structural. I've been going to China regularly over the last 10 years, and they've always been talking about cleaning up, but it's real now.

"We won't know until steel prices come off, and see how the market reacts ... but the higher-grade iron ore produced by the likes of BHP (ASX: BHP) and Rio Tinto (ASX: RIO) may stay up there for longer."

On a broader macroeconomic level, he believes the corporate environment is ripe for a pick-up in merger and acquisition activity--which he tips to be a big feature of 2018.

"What's different now over the last few years is that the economy ... and everyone [in terms of company owners] is feeling better about themselves. There's a view that interest rates are at their bottom and they're only likely to move higher," Potter says.

While charts of economic growth show Australia's ASX 200 lagging considerably behind Japan, the rest of Asia, the US, and Europe, Potter thinks "we're at that early stage of the cycle".

"We are being held back a bit by the banks, because they are raising so much capital and are such a big part of the market--with their EPS being quite poor, they've been dragging down the market," he says. 

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Glenn Freeman is a senior editor at Morningstar.

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