Bank shares a dilemma for self-funded retirees

What to do with bank shares is proving a challenge for many self-funded retirees. Picture: iStock

The challenge facing Australia’s largest investment firm, Australian Foundation Investment Company (AFIC), is one that is plaguing vast areas of the self-funded retirement community: What should be done with bank shares?

Since 1928 AFIC has been a wonderful, well-managed investment vehicle for Australians looking for a conservative investment policy with low management costs. AFIC invests in leading companies and rarely sells them.

But at the AFIC annual meeting last week there was a clear tweak in the investment strategy and AFIC announced that it had reduced the number of companies in its portfolio and was looking for companies with “a sustainable competitive advantage with unique assets producing strong returns on capital……..businesses that can grow over the long term, producing growing dividends”.

As James Kirby set out in The Weekend Australian, AFIC implemented that strategy by increasing its holding in Macquarie, CSL, Goodman, Ramsay Health Care, James Hardie, Sydney Airport, Sonic Health Care and APA and also added a small quantity of what it calls “nursery stocks” including QBE, Xero and NextDC.

That strategy is exactly what a company like AFIC should be doing in the current environment. But then you look at the portfolio as of September 30. Some 22.6 per cent of the group’s shares were held in four banks, Commonwealth Bank, Westpac, NAB and ANZ.

AFIC says that while bank earnings growth is likely to be low in the short term, in the longer term banks will be a “key part” of financing the Australian economy.

Yet almost every day there are warnings that while banks may remain a “key part” of financing the Australian economy, their margins are set to fall.

Just this week Josh Frydenberg “sooled” the Australian Competition and Consumer Commission onto the banks because to maintain their margins banks had not passed on the full interest rate cuts despite thrashing depositor rates. And for those unfamiliar with Australian slang, “sooled” means to set dogs to attack onto something such as a rabbit or vermin---a fair description of the way Frydenberg’s actions came across.

The banks warn that if Frydenberg’s “sooling” is successful then both their profits and credit ratings will fall.

The attack on banks goes further. In almost every area of bank business new competitors are arising including Afterpay-style lenders in credit cards and the multitude of non-bank lenders in business and housing loans. Mortgage brokers have taken virtual control of banks’ home loan distribution business and in foreign currency Melbourne’s Airwallex has substantially lowered the cost of access to foreign currency internet transactions.

Airwallex is looking to extend its foreign currency banking systems into other areas and has a big team of software developers in Melbourne preparing to launch low margin banking product systems on the global stage as well as Australia.

There are similar attempts taking place around the world and ex Telstra CEO David Thodey is backing Tyro Payments, which is tackling banks in EFTPOS terminals. It is very hard to find a share broker that is enthusiastic about bank shares in the longer term and overseas institutions have been selling Australian bank shares.

UBS expects further dividend cuts and banks to re-base their targeted return on equity to more realistic levels for an ultra-low rate environment. UBS concludes that following the rerating, banks look expensive on price earnings ratios around 15 with falling earnings per share profiles over the medium term.

And billions are being paid out to rectify consumer wrongs ---- money that should be invested in new technology to cope with the new tech players.

Starting from scratch and using the investment criteria that AFIC has set out, there is no way the company would invest 22 per cent of its money in four big banks. Yet the four banks carry a high yield and enable AFIC and other investment companies to pay big dividends. And that dilemma extends to vast areas of the self-funded retiree community.

Any significant reduction in bank dividends would cause AFIC to substantially reduce its dividends. But the same thing would happen if AFIC sold bank shares because replacement yields would be lower. It is these high bank dividends that are enabling many retirees to maintain their standard of living in this low interest rate environment.

AFIC’s before-tax asset backing at September 30 was $6.48 whereas the after tax backing was $5.51. The share market is closely tied to the before-tax asset backing because AFIC does not sell its major holdings.

If AFIC sold a major part of its bank portfolio it would trigger a big tax payment. Yet given the situation maybe AFIC should consider that strategy.

I will always recall the newspaper days when the so-called “rivers of gold” were looking uncertain at Fairfax.

What Fairfax and other newspapers had to do at that time was to adjust strategies to be major players in the new internet classified advertisement environment. But most of the efforts were concentrated on maintaining the old revenue streams and hoping that the inevitable would not take place. But of course it did.

I feel for the board of AFIC because there are no easy solutions and the dilemma of AFIC is reflected in the individual investment strategies of many retirees.

If you are going to make a change in investment strategy the best time to do it is when the market is strong.