Bank stocks the place to start for bargain hunters

With the prospect of rate rises receding into the distance, it’s time to reconsider bank stocks.

Earlier this year — on Saturday February 21 to be precise — I wrote here that Australian bank stocks had run ahead of themselves. It was obvious then that as an investor if you did not “take some profits off the table” the market would sooner or later do it for you.

At the tail end of this remarkable week, stocks came back to earth. In fact they came back into value, and with the prospect of rate rises receding into the distance, it’s time to reconsider bank stocks.

But first a quick recap, using CBA as the benchmark. In February, it was priced at $90 on a price earnings ratio (P/E) of 16.3 and a dividend yield of 4.6 per cent. Yesterday the bank was trading at about $75.70 on a P/E of about 13.7 and a dividend yield of 5.5 per cent. The pendulum has swung and anyone looking to re-enter the market in major stocks has to start with the banks.

Apart from the crucial fact that the market has sliced about 20 per cent off all our major bank stock prices, the other key issue that has occurred since February is that the big banks have made serious headway in raising capital. No two capital raisings have been for the same set of reasons, but ANZ, CBA and NAB have all announced substantial moves. WBC has yet to act.

We also now have “earnings visibility” at the banks — that is, they have reported earnings largely in line with expectations. CBA, the only one to report full-year results, has recorded a 5 per cent improvement — a lot better than the average big cap stock this season.

Now we can get any number of analysts to worry and tremble about what might go wrong with bank stocks in the months ahead — more regulation, more capital raising, slowing bank credit, a housing downturn, etc. But, for the income investor, the issue is primarily what can the banks pay in terms of dividend and what risk is there that these payments will not come through?

It’s certainly true that banks have come close to a dividend payout ceiling, that is, they just can’t pay much more out of profits in dividends. But the chances that any major banks will cut its dividend is slim; the only time in recent years banks cut dividends was an across the board reduction among the big four of about 25 per cent in the depths of the GFC.

In contrast, other stock categories that are regularly cited as alternative to banks for income, such as insurers and industrials, are not as dependable at all. For example, one of the outstanding items in the recent results season among financial stocks was the insurer IAG, which actually cut its full-year cash dividend.

Remember, the bank yields mentioned are pre-franking; you can add at least 1.5 per cent for most people in terms of after-tax numbers.

So banks in general are now offering an effective (grossed up) yield of 7-8 per cent against cash deposit rates of 2-3 per cent, and there is still a chance these cash rates may yet drop, in the domestic market at least.

Taking the big banks one by one — here’s the position:

●CBA: The biggest of our banks is now offering a yield of 5.5 per cent and will have a stronger capital basis at the end of its current raising. The retail end of this raising is still open with 1-for-23 rights issue priced at $71.50.

I’m not surprised leading bank analyst Jonathan Mott at UBS upgraded his call on CBA this week to a buy, with a target of $87.00. Certainly with value investors estimating an intrinsic value on CBA of at least $83.00 (against $75.70 now) this most highly rated bank again looks compelling.

●ANZ: The bank has a long- running Asian expansion strategy under the guidance of chief executive Mike Smith. Ironically, it’s the Asian dimension that goes a fair way towards explaining why ANZ has the lowest P/E of the majors at just 10.4 now. But then, it has a whopping dividend yield of 6.5 per cent. What’s more, many analysts will argue it is these offshore operations that offer the prospect of serious earnings growth, which would propel dividend growth — in a word, the highest yield for the highest risk among the big four.

●NAB: The Melbourne bank has a dividend yield of 6.2 per cent. In common with ANZ there is elevated risk here as the group is still in recovery mode under newish CEO Andrew Thorburn and in the middle of the delicate business of extracting itself from Britain.

But as Eureka Report income analyst James Samson recently explained: “The difference between the 6.8 per cent grossed up dividend yield forecast for CBA and the 8.02 per cent forecast for NAB is material”.

●Westpac: The Sydney bank is traditionally the most conservative of the major banks, a factor which should translate into it being the most reliable yield payer. WBC has not made its move in terms of a capital raising and though it has sold of its interests in BT funds management, analysts expect the bank will have to still raise more money. The issue now for Westpac is that it will be more expensive to raise any money using scrip. In any event the bank is trading on a P/E of a shade under 13 times and a yield of 5.9 per cent.

Nobody knows if the wider market correction is over — but for serious investors, it’s clear that markets are already at levels that are good enough for long-term players.

The key consideration now is whether as an investor you have too much bank stock in your portfolio. If you are lucky enough to be at the beginning of accumulating a share portfolio, start here with any bank that suits you.

If, more typically, you had an uncomfortably large allocation to banks, then you’ve had your portfolio rebalanced for you by the correction — and a closer look you might justify adding more.