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Where to from here for Australia's wide moat major banks?

David Ellis, CPA  |  13 Apr 2018Text size  Decrease  Increase  |  
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The major banks seem to be operating in parallel universes. On the one hand it is all doom and gloom with investors facing a daily avalanche of negativity, including disturbing revelations from the Royal Commission, Productivity Commission reviews, ASIC inquiries, APRA capital changes, macro-prudential limits on lending and unfriendly policy proposals from the federal opposition to name a few. Not surprisingly, bank share prices have suffered.

On the other hand, Australian major banks continue to benefit from surprisingly solid fundamentals delivering modest earnings growth. Capital levels are strong, loan quality is pristine, the economy continues to chug along at a respectable 2-3% GDP rate, employment growth is strong, credit growth is solid, inflation is low, and the housing market is stabilising. Attractive fully-franked dividends are not under threat and capital returns are possible during the next few years. The risk of a recession in Australia remains low and surprisingly, the federal budget deficit appears to be shrinking faster than expected. This "Goldilocks" operating environment is good for banks and we see it persisting for several years at least.

The incessant news flow from sensationalist media and grandstanding politicians has weighed heavily on bank share prices, offering attractive entry points for investors. Westpac provides best upside, but all four major banks are undervalued relative to our fair value estimates. Investors should remain calm; current headwinds will dissipate after a difficult next 12 months and longer term we expect satisfactory shareholder returns, albeit lower than the stellar returns experienced during the past decade. Major bank forward price earnings ratios have contracted to an average of 12 times from 13 times five months ago and are now below long-term averages. Political and regulatory risks are still rising, but we believe current bank share prices broadly reflect these risks.

Exhibit 1: Major bank forward price to earnings (P/E) ratios

chart Source: Thomson Reuters, Morningstar

Banking is an industry Australia excels in

Make no mistake, banking is an industry Australia really excels in and the four major banks set a global benchmark. The major banks are world class for profitability and shareholder returns, though culture must improve. They boast impressive peer comparisons across operational efficiency, loan quality, risk management, returns on equity, capital levels and liquidity. Balance sheets and funding profiles are significantly stronger than pre-GFC levels and future earnings will withstand digital disruption. Strong fundamentals underpin the outlook for long-term earnings growth.

The major banks are both a strategic and economic necessity for Australia, playing a key role as importers of capital from international markets. Australia has long been unable to raise sufficient capital domestically to fund multi-decade economic expansion. Yet we are one of the wealthiest nations in the world with long-term wealth creation supported by a strong and profitable banking sector.

Geopolitical and economic risks are always present, but manageable

The main risk over the medium term is another global credit crisis, with flow-on implications for domestic lending, house prices, the economy and employment. A credit crisis would make it more difficult and costly for the banks to fund existing lending, creating a slump in lending growth and cause bad debts to rise. However, this is not our base case and in any event the banks have stronger financial positions than pre-GFC and can expect support from the government and the RBA in the event of a crisis.

Digital disruption from global tech giants such as Google, Apple, Amazon, Alibaba and Tencent as well as start-ups is a risk, but the major banks continue to invest heavily in product and service innovation to retain and grow customer numbers. Despite media and political commentary to the contrary, major bank customers trust their banks to protect their life savings and personal details from cyberattack. Customer trust is a key competitive advantage of the major banks.

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David Ellis is Morningstar's head of Australian banking research, Australia and New Zealand. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

The author's retirement fund owns shares in all four Australian major banks.

 


Your feedback on this week’s Overview is always welcome. Send your comments to YMW@morningstar.com. We’d love to hear from you.

 


© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is a senior equity analyst in the equity research team at Morningstar.

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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