AFR: Banks vs resource stocks

Australian Financial Review: Smart Money, June 2012

Half a world away, troubles in Europe are creating the most miserable outlook for world markets since the global financial crisis – indeed, Europe appears to be the GFC’s grim second act. A little closer to home, a slowing Chinese economy is putting sand in the gears of the one apparently reliable engine of global economic growth. It’s bleak out there.

The two appear to be based on two very different set of circumstances, and to affect two different sectors. The European sovereign debt crisis hits banks hardest, particularly those banks that have exposure to Southern European debt. China, by contrast, affects commodities more than anything else, since a flagging Chinese economy means less demand for raw materials.

And that’s where these distant global problems combine and come home – because no two sectors dominate Australian portfolios more than banks and resources. Financials, ex-property, make up just under 40% of the S&P/ASX200, and materials just under 22%, not counting the related industrials and energy sectors that make up about another 13%.  All five of the nation’s largest stocks – BHP Billiton, CBA, Westpac, ANZ and NAB – are within this group, with fellow heavyweight Rio Tinto not far behind. Australians are unquestionably exposed to these difficult global themes.

This raises several questions. How resilient will these sectors be to global shocks? Do we have too much money in these areas? Or is the bad news in the price already and should we in fact be buying more? We asked six fund managers for the answers – and found that there’s no consensus on where we should be.

The banks

Let’s start with the banks. It’s widely agreed that Australian banks look far better than most of their counterparts in Europe and the US, as was demonstrably the case in the GFC. “The Australian banks are in a very different position to most of their peers overseas, given that we haven’t had the financial or real estate crisis in the Australian market that we’ve had elsewhere in the west,” says Johan Carlberg, principal and portfolio manager at Alphinity Investment Management. “The capital position, even though they’ve had to raise some capital to get there, has been stronger as well. It does set them apart from the rest of the world.” On top of that, Australian bank exposure to Europe is very low; NAB has the most, through its UK operations, but has been progressively reducing that.

Brad Potter at Tyndall Asset Management agrees. “People are struggling with the idea of owning a bank while the whole European situation is occurring,” he says. “But banks are in a much better position than they were in the GFC. Now, everyone knows that if we get a credit lock-up, there’s a playbook that occurs.” Specifically, the government underwrites deposits and the securitisation of mortgages so banks can continue lending and borrowing – that’s what happened in the GFC and would no doubt happen again. “So from a risk perspective, banks aren’t going to go under.”

In particular, availability of funds – the crunch that killed several banks globally in 2008 – no longer looks like a tough issue. Since the crisis, Australian banks have found a whole new source of funds with the new covered bond market. “They have strong capital positions and have been working hard since the GFC to reduce their reliance on global funding markets, with a good deal of success,” says Katie Hudson, portfolio manager at Goldman Sachs Asset Management.

Perhaps a bigger threat is homegrown: the prospect of a housing price collapse and a rise in delinquency ratios. “I don’t think Australia is any different to the rest of the world in terms of the impact a housing crisis could have,” says Carlberg. He says that a trigger for a housing crisis in Australia would be a significantly higher unemployment rate, and this would clearly be a major problem for the banks. “On the other hand, the base case can’t be that we are going to have a significant rise in unemployment given the underlying strength in the economy.”

Hugh MacNally, director and founding shareholder of Private Portfolio Managers, does feel that Australian residential property is overpriced and that a correction is due, with an attendant impact on the banks. “In our view we will undoubtedly see a real decline in value, so the question one would ask is: is there sufficient provision on the bank balance sheets? We’d say yes, and it will play out over a reasonably long period of time, without a disastrous effect on the banks’ security.”

But if we accept that banks are not going to go under, there’s still the challenge of how they’re going to grow. Beyond funding, “the biggest issue for the Australian banks is anemic credit growth from a protracted deleveraging phase,” says Hudson. “There is a growing acceptance that there is a structural shift in the Australian market with consumers and corporates operating with lower levels of debt.” Banks are trying to reduce their own costs and change their business models to compensate, but can it be enough? Or are we stuck with a sector which, while not in danger, has no prospect of energetic revival?

“The strength we see is the very strong oligopolistic position the banks have, and the unlikelihood of major competitors coming in,” says MacNally, who also sees little enthusiasm for any structured finance products to compete with bank mortgages. “Banks are in a pretty strong position, long-term, and eventually credit growth will return in a modest fashion.”

Smart fund managers know that the outlook for stocks is only half the issue; there’s also the question of their valuation today. Opinion here is divided. “Bank stocks look attractive, but then again the whole equity market looks attractively priced,” says Carlberg. “Most stocks look cheap and the banks are no exception, but at the same time you do need to get sustainable earnings growth in the market to go forward.”

Brad Potter at Tyndall Asset Management disagrees. “They’re not cheap by any stretch of the imagination,” he says. “On a relative P/E basis they’re at the upper end of the range. I wouldn’t say they’re expensive, they’re just not cheap.” He, instead, finds far better value in resources

Resources

How about resources? Carlberg, who has preferred banks over resources for the last year, sees a market that “is trying to work a few thing out” – such as what growth rate China will achieve in the next few years, when new capacity will hit the market, and whether we will see a long term reduction in commodity prices.  On China, Carlberg says the market has been too pessimistic in the short term, and he has been buying stocks as a consequence. “I don’t see the Chinese economy collapsing, I see a slowdown in growth rates.” In that light, recent sell-offs in resources are making them look appealing. “But at the same time we are certainly getting closer to the end of the commodity supercycle that began in 2003-4 with that sharp interruption from the GFC in the middle.”

Opinions on resources cover the whole gamut from opportunity to fright. Hudson, basing her research on frequent Goldman trips to China, is more bearish on resources than banks; indeed, the house has had a negative view on resources for 18 months now, based largely on weakening demand from China. “It is likely we have seen earnings peak for the resources sector,” she says.

At the other extreme, David Whitten is executive chairman and portfolio manager at 90 West, a new natural resources-focused fund manager. His new fund was launched in June, and he found the timing exceptional. “I’m genuinely quite excited by this correction. I can see real value.”

How to play it, though? With established names, Whitten says. “There’s no need to go past quality,” he says. “Small stocks have been decimated but it’s too early for that. The bounce will come with quality.”

This is a common view: that if resources represent opportunity, then start with the big guys whose businesses you know well. Potter at Tyndall, who says “quality resources look extraordinarily cheap, trading at huge discounts to DCF [discounted cash flow] and low PEs,” agrees with Whitten.  “Your marginal dollar should be moving into good quality resource companies,” he says. “You don’t have to go down the spectrum: BHP and Rio are trading at significant discounts to NPV. You don’t have to go for lower quality.”

After all, there are many types of commodity stock out there. Iron ore is the heart of Australia’s resource heavyweights, dominating EBIT at both BHP and Rio. “In the short term there is pricing pressure, but you’ve got to remember the costs of producing it are very low,” says Whitten. “These are quality, high margin businesses.” Also, both companies have the infrastructure in place to expand existing facilities where necessary. “Brownfield expansion is how you make money, not by launching Greenfield projects at times of uncertainty.”

He adds: “There are concerns about them delaying projects, but both have the flexibility of being able to do that,” he says. “To my mind that’s the sign of a quality company: by focusing on high return businesses, it can stand still and yet continue to grow.”

Smaller names, however, tend to bring more risk with them in this environment. Potter notes that with heavy capex, returns on capital are lower, and that big names have a better capacity to withstand that than smaller ones; he also notes that smaller operators will struggle to get bank funding in a harsh environment.

“The first distinction to make is to look at who actually has a project that is viable,” Carlberg adds. “There are a number of companies that have projects that have always looked a bit marginal, and now starting to look very marginal, and that probably now will not happen. You are better to support the ones where not only are the projects viable and funded, but they have the infrastructure: even if a mine is OK, a lot of infrastructure has to be put in place as well.” He, too, prefers iron ore (and coal) names over other metals like copper; others have particular enthusiasms, like Whitten’s belief in agricultural assets like potash, used in fertilizer manufacturing in the developed world.

Analysts are generally not enthralled by gold stocks. Gold itself has increased about 80% since 2008 in US dollars, yet gold stocks by and large have fallen over the same period (it’s worth pointing out that gold bullion has not appreciated from the Australian perspective because of the strength of the Australian dollar over the same period). “I haven’t seen a valuation to say that an ounce of gold is cheap in terms of equities,” says Whitten. Hudson, too, has doubts about gold stocks – “you need to distinguish the performance of gold as a commodity form the outlook for gold stocks” – and remains more positive about banks generally than resources.

Longer term, the dynamics around resource demand are unarguable. “The dynamics of population growth and increasing prosperity, especially in Asia, with the trend towards urbanization continue to drive demand for natural resources, steel and iron,” Whitten says. But still, many managers are bearish.

MacNally says that “Our view is the long term prospects for resources are not good.” There are, he says, two things he doesn’t like about this point in the cycle: massive capital expenditure, and the high prices relative to cost of production. He expects a retreat. “I remember BHP 10 years ago was earning a billion and a half dollars and its capex was about the same. Now it’s 10 times that level. Longer term, there’s probably a retreat to more normal levels.” He is underweight the sector.

In recent months it has been commonplace for economists to talk about the end of the commodities supercycle. Are they right? “The law of big numbers has always said you cannot run China at 8.5% to 10% forever,” says Potter. “And nobody’s ever forecast that because nobody’s ever believed it. Similarly nobody says iron ore stays at $140 forever. That’s in the numbers, it’s in the value of their stocks. I have no doubt that growth will slow, but I’m not of the view the supercycle is finished.”

Fear and loathing

So, across the market, should we expect Europe to bring disaster? “The short answer is no,” MacNally says. “There is a tendency to catastrophize and assume a whole lot of consequences from a particular event, but our view would be that rarely does that play out.

“What we’d look at is company earnings,” he says. Corporates are in pretty good condition, with strong balance sheets, and we regard that as being something one can rely on.”

In some ways, we are better placed this time around. “In 2008, Lehman going under was a big shock for the market; nobody anticipated it,” says Scott Bennett at Russell Investments. “If you look at markets today, the issue with Greece has been going on for three years. If Greece were to leave the eurozone, we wouldn’t see the same surprise as 2008 when markets dropped off a cliff. A large part of it is priced in the equity market already.”

But there is a problem, the bane of share market investors: reason and fundamentals go out the window when people panic. “With any kind of equity investment, you are always at the whims of investor sentiment,” Bennett says. “Market greed or fear will determine the price that gets traded at the end of the day.”

WHICH STOCKS?

Carlberg prefers Westpac among the banks. “They have the best balance between revenue growth and cost control.” Among commodities, he goes for companies with iron ore exposure, notably Rio Tinto and Fortescue Mining. Rio is his largest exposure in the sector; “strong balance sheet and good exposure to iron ore.”

MacNally says he “takes a portfolio view of the four banks – the returns have been so close it’s not a very fruitful exercise trying to pick one over the other.” If forced, he says he’d see NAB more favourably than ANZ, “but only marginally.”

Bennett favours Westpac and NAB, “purely based on fundamental valuations and yield.” CBA is probably the best quality, he says, but is more expensive as a consequence, and has the lowest yield.

And Whitten’s favourite commodities stock is not Australian – it’s Canada’s Potash Corp.

DIVIDENDS

Australia, more than any other major stock market, is a place where the dividend yield is a key part of an investment decision. Many smart investors invest in stocks with the yield the main consideration, and in particular have gone to the banks (and Telstra) to do so. It’s not a bad idea: stable income from stocks that, though they might fall, won’t ever go under.

How do dividends look in this environment? Scott Bennett at Russell Investments says one of the best characteristics about bank stocks is “the strong underlying support for dividends. If you look across the four major banks, you’re getting around 10% yield once you include the franking credits,” he says. “That’s almost double what you might get in a term deposit.”

Better still, “one of the big differences we see compared to 2009 is that the payout ratios have come down. Banks aren’t stretching balance sheets to fund those dividends.” In 2009 dividend payouts for the big four were approaching 100% of earnings; today they stand around 70%, closer to long-term averages, and suggesting that dividends are sustainable.

Others agree. “The dividends of the banks are higher than they have been in the last 10 years, so from that perspective they look more attractive,” says Carlberg. “In fact, when you look at traditional comparisons – such as bank yields relative to bond yields – they’re extremely attractive.”

Potter says that banks pay “a pretty good dividend yield. Everyone knows that earnings growth is in the zero to 5% level, rather than the double digit level they had for a long time, and credit growth is slow. They generate more capital than they would in a higher credit growth environment so their payout ratios are higher. That means dividends increase at a greater rate than earnings growth would suggest.”

MacNally says bank dividends are “sustainable and definitely attractive, bearing in mind that for a significant proportion of investors the yield is grossed up.”

Resources are less commonly associated with being dividend plays. “I don’t think any Australian investors should buy for franking credits or dividend yield,” says Whitten. That said, outside Australia, he does note some areas where some very yields can be found, notably in what he calls mid-stream businesses in the US; Kinder Morgan would be an example.

MacNally is blunt. On resources, notwithstanding special dividends or buybacks of the sort BHP had last year, “you’re not buying the resource stocks for their dividend yield,” he says.