Friday, 14 August 2015

Banks: Domestic, Overseas and Dividends

Banks and the ASX
The ASX has never been equally diversified, as it is always skewed towards the industries in which we specialise in, particularly mining and oligopolies that dominate many sectors. However the domination of the banks is unprecedented. They comprise of 42% of the ASX 200 index, and, when one considers most of their business is mortgage lending, this means the stock market is heavily exposed to the housing boom. In the US, financial stocks represent only 16% of the S & P 500 index.

This is not the first time the market has seen skewness. Technology, media and telecommunications made up 37% of the index in 2000 – News Corp alone accounted for 20%. Mining then took over in 2008 and accounted for 39% of the index with the market cap of TMTs reduced to 10%.

However what makes the banks noteworthy is that they are providing high dividend yield and tax advantages of imputation (dividends are tax free to the extent that the company tax has already been paid). In the TMT boom, many stocks had no earnings at all, and mining companies tend to reinvest earnings rather than pay dividends. In an environment of low interest rates across the developed world, which has created unfavourable investment conditions, those dividend yields are one area that investors expect good returns to be at. However amid growing signs that the banks are under pressure (including Australian ones, where rising interest rates signal potentially higher risk from the housing bubble for creditors) the Sharemarket faces a higher degree of vulnerability.

Global Banks
Financials are both globally and domestically oriented in the sense that it can depend on the valuation in that country, or it is mostly affected by the global regulatory environment and interest rates. Global banks have proven to diversify Australian equity portfolios focussed on dividend distributions, with the overseas banking sectors provide higher returns over the past 12 months than Australian ones, and trading with consistent upside in earnings and improving return on equity. This is the result of a change in regulations, particularly across Europe, which have required these institutions to increase capital and sell assets.

The traditional P/E is not typically used to value overseas banks as they represent more than operating earnings, rather return on equity or price to book ratios would better represent how they operate - essentially as an asset pool. Furthermore their dividend yields do not account for most of the valuation, and some banks do not pay out dividends at all to satisfy their capital requirements. This nonetheless is on a declining trend. Therefore currently the difference between global banks and Australian banks is their dividend payout ratio. Global banks usually pay out 30-40% of their earnings in dividends, with many including buybacks in addition. These buybacks can represent a further 20-40% of the payout.

Global banks therefore diversify an Australian investor’s portfolio. They not only tend to outperform our banks, but also diversify risks related to lending growth, capital structure and the interest rate. As a result of this they compensate the lack of dividends with capital growth. Furthermore our banks have similar profiles that are quite weighted in mortgage lending. Overseas banks will reduce the risk from overexposure to the housing bubble. However because of the changing regulatory and digital environment, share price movements tend to influence weighting and selections of the global banks’ equities more than the Australian counterparts.

Dividends and Capital Gain
Australia’s ‘dividend market’ has been driven mostly from the growth in self-funded retirees, and also government bond yields trending lower over the last five years from both lower domestic and global interest rates from the quantitative easing in Europe, Japan and the US. High yielding stocks are therefore sought after as substitutes for fixed income investments. The 10 largest cap ASX companies have seen dividend yields converge over the past 5 years. However simply going long in these seemingly blue chip stocks assumes identical risk and return profiles, which is not the case.

Expected return also takes into account capital gain and loss. BHP, CBA, RIO and TLS are examples of the ASX 10 companies that have forecasted negative future values for year 1 and BHP and RIO continue this downward trend for year 2, down 7.3% and 2.5% respectively. Meanwhile forecast dividend yield for these stocks remain attractive at 4.20%-4.97%. MYR has a dividend yield of over 8%, yet its share price fell over 40% during 2014. On the other hand CSL out of the ASX 10 has the lowest dividend yield at 1.42% although they have high value growth from reinvesting earnings at relatively higher rates of return.  Therefore investors should be aware of the risk of capital loss, or the probability of capital gain, at the expense of dividend income.

Australia’s market, known for its stable banking industry and their appeal to retail investors, is now becoming an interesting mix with global equities if future prospects and value is taken into account. Financials are reporting record high dividend payouts (the proportion of earnings paid as dividends) at 71%. This could however be also attributed to weaker corporate profits. Furthermore this is not necessarily positive for shareholders in the long term, with pressure to maintain this high dividend payout ratio (numerous factors contribute to this pressure to either pay at or more than historical rates - see previous posts) subtracting capital for the firm to use for investment purposes. Investing for growth paths the way for sustainable rises in earnings, and only then are increases in the share price and dividends enabled. 

Australian Financial Review, Reuters, CBA

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