Big banks ‘ready to ride recovery’, says Yarra’s Dion Hershan

Influential investor Dion Hershan predicts two or three years of double-digit earnings growth for the major banks.

Influential investor Dion Hershan has predicted two or three years of double-digit earnings growth for the major banks. Picture: Hollie Adams/The Australian

Influential investor Dion Hershan has predicted two or three years of double-digit earnings growth for the major banks, while lashing the sector for its persistent failure to slash operating costs.

Absolute cost reductions have been a recent feature of ANZ financial results, and Commonwealth Bank chief executive Matt Comyn has said he is targeting a lower overall cost base.

However, industry-wide cost savings from branch rationalisation and investments in automation have been as elusive as revenue gains, soaked up by spending on risk and compliance, wage inflation and COVID-associated expenses.

Mr Hershan, managing director and head of Australian equities at Yarra Capital Manage­ment, said he expected, rather than hoped, that the majors would start to reap some productivity dividends soon.

“It’s fair to say that one of the major disappointments for the sector in the last 3 years is that we haven’t seen a substantial reduction in operating costs,” he said.

“The banks have operated very much on a trust-me basis, investing billions of dollars in technology with a view to productivity gains in the future, but frankly, you need a microscope to find them.”

Mr Hershan’s confidence about the earnings outlook was echoed last week in a report by Morgan Stanley and comes ahead of Commonwealth Bank’s half-year profit announcement on February 10.

Morgan Stanley forecast the major banks would outperform the ASX200 in 2021 because of domestic economic trends, a cyclical recovery in earnings, healthy balance sheets, a lower overall risk profile, and rotation by investors in other sectors.

Yarra is an $8bn fund with an overweight position worth hundreds of millions of dollars in Australian banks.

While the fund has lightened its exposure in recent years, it encompasses not just equities but also hybrids, residential mortgage-backed securities and corporate debt.

Mr Hershan said that, overall, he had a positive outlook on the sector, although he wasn’t doing “cartwheels of excitement” because strategic execution by some banks wasn’t as crisp as expected and a lot of issues still had to be addressed.

That said, it was now clear that the economy had made an extraordinary recovery from the gates of COVID hell.

“We’re constructive on banks; we know it’s a low-growth, cyclical sector, but if you reflect on where the economy was in the deep, dark days of March, there was a consensus view that property prices would fall by 15-20 per cent and we were on the cusp of the next Great Depression,” the Yarra chief said.

“I think it’s obvious now that those fears were greatly exaggerated, and if you look at where we are with COVID, vaccines and the pretty steep V-shaped recovery, it plays to the banks very, very nicely.

“In a world which is income-starved, we think the banks will start to pay really good dividends again in fiscal 2022.”

Yarra’s approach to investing in banks is to focus on a handful of key variables, knowing that the natural leverage in the financial system means that their impact will be magnified, particularly if some of them shift in tandem.

Back in March, as COVID tightened its grip, the situation looked grim.

While bank capital ratios were solid, there was an expectation that bad debts would soar, the squeeze on interest margins would intensify, and cost structures would remain bloated.

The variables were stacked against the system, with the multiplier effect due to leverage only adding to the pain.

Ten months later, it is Mr Hershan’s firm view that the tide has dramatically turned. “We saw bank earnings drop 30-40 per cent in fiscal 2020, which is enormous for a large part of the market,” he said.

“But I think the next few years should see a significant recovery in earnings, mostly because bad debts will be coming down, so we could have two or maybe three years of double-digit earnings growth.

“And it’s not because these are high-growth businesses; it’s because they fell significantly and they’re progressively recovering.”

Optimism about earnings comes ahead of the Commonwealth Bank’s half-year profit announcement on February 10.

On credit growth, the outlook for business lending was muted, with a modest improvement driven by the instant asset write-off program announced in the federal budget.

But more importantly, expectations for mortgage growth had switched from sharply negative to a consensus that the property market was healing, with prices and lending growth on the way up.

With home loans comprising about 65 per cent of major-bank balance sheets, it was unquestionably good news for the sector.

Interest margins, meanwhile, were under extreme pressure as official rates hovered around zero and mortgage competition intensified.

“The net interest margin won’t significantly rebound but the pressure will ease as mortgage growth accelerates because there will be more for everyone,” Mr Hershan said.

“We see margins plateauing from here, which is a good outcome compared to where they have been.”

The industry’s high operating costs have been an ongoing frustration for Yarra.

However, in a welcome change, the bad-debt cloud enveloping the industry has lifted after heavy provisions were booked under the new forward-looking accounting standard in the March half-year.

“A lot of people in the banks thought that the sky might fall in, and it’s worth noting that almost all of the provisions were put in place in March, some of them prior to JobKeeper,” Mr Hershan.

“Since then, we’ve seen very few large corporate failures so we’re not talking about a GFC-style event, and just as the economy has healed so too have the mortgage and SME loan deferrals, which have dropped by 70-80 per cent from the peak.

“That’s extraordinary, and you’d expect them to fall further.”

The Yarra boss said the sector should be yielding 5-5.5 per cent in fiscal 2022. “And in a world of zero rates, that’s got to be tempting for a lot of investors,” he said.