In the first of this two-part series (Part 1: Commonwealth Bank of Australia – The end of an era?) released yesterday, we looked at some of the reasons as to why Commonwealth Bank of Australia (ASX: CBA), and each of its major rivals, have managed to generate such strong returns for investors in recent years.
Indeed, one of the key reasons behind the Big Four Banks' recent success has been the low interest rate environment, sparked by the Global Financial Crisis between 2008 and 2009 which has led to a record-low cash rate of just 2 per cent, as of the beginning of this month. This has acted as a major catalyst behind falling loan impairment charges which has further contributed to the bank's record earnings in recent periods.
Figure 4. Source: Commonwealth Bank annual reports
But movements in bad debts are "pro-cyclical", meaning that they cannot, and will not, be sustained. As they increase, pressure will be applied to the bank's ability to grow earnings, while at the same time competitive forces from Australia and New Zealand Banking Group (ASX: ANZ), National Australia Bank Ltd. (ASX: NAB) and Westpac Banking Corp (ASX: WBC) are taking a toll on Commonwealth Bank's net interest margin (NIM), which will further constrict earnings growth.
Again, you can read all about that in the first part of this series by clicking here.
In this second part however, we'll look at some of the other economic forces which could seriously impact the bank's ability to generate market-beating returns, including the red-hot property market, requirements to hold greater amounts of capital, and its ability to grow or even maintain its current dividend yield (who could create a write-up on one of the banks without at least mentioning dividends?).
Financial Planning
Commonwealth Bank's financial planning arm has been a key topic in the media in recent years after some of its advisors were revealed to have provided poor advice that was not in the best interests of its clients. In its 2014 Annual Report, the bank said that it had already paid out $52 million in compensation to more than 1,100 clients.
Given that the bank's net profit ("cash basis") was a remarkable $8.68 billion during the year, a total payout of $52 million is hardly something for long-term investors to lose sleep over, but it's the reputational implications that could be cause for concern.
Non-interest earning income (that is income derived from activities outside of lending) will play a key role in all of the banks' growth strategies moving forward and events like these could seriously impact customer confidence. Commonwealth Bank appears to be taking the right steps to righting this wrong, but any more events like these could seriously damage its reputation going forward.
Property Market
Commonwealth Bank is Australia's biggest bank with a market capitalisation of $136.7 billion. As at 30 June 2014, it controlled a massive 28.6% of Australian household deposits and 24.9% of credit cards, while it is also boasted the biggest mortgage book with a 25.4% share of the market.
While this has been a huge tailwind for Commonwealth Bank (and each of the other banks) as house prices have been skyrocketing, it also puts them at huge risk should the market suddenly crash. Indeed, recent figures provided by CoreLogic RP showed that Melbourne house prices had risen 10.6% in the 12 months to April and an even more alarming 14.5% for Sydney, with the median dwelling price ballooning out to $732,500.
Figure 5. Source: CoreLogic RP
Astonishingly, the Fairfax press also highlighted that Sydney home prices are growing 5x faster than wages, indicating the unsustainability of these inflated prices. Although the RBA is adamant that a 'bubble' hasn't yet been created, it is wary of lowering interest rates any further in case of adding fuel to the fire.
Notably, Commonwealth Bank and Westpac would likely be hit the hardest in the event of a downturn in the property market, given their heavy exposure to the sector.
Basel III & Capital Requirements
The market's regulators have recognised the headwinds facing the economy, both locally and globally, and indicated that tougher capital requirements are necessary to act as a buffer in the event of another severe downturn (indeed, some of the more 'bearish' analysts are predicting a crisis even more severe than the GFC).
During the latest quarter (ended 31 March 2015), Commonwealth Bank said that its Basel III Common Equity Tier 1 (CET1) APRA ratio had improved by 20 basis points to 8.7%, but that is still lower than the 10% to 11.7% capital ratio suggested as a plausible range in David Murray's 2014 Financial System Inquiry. This suggests that the bank could have to raise significantly more over the coming years.
To satisfy this likely requirement, there could be a significant impact on the bank's return on equity, or RoE (that is, the profit it makes on the money shareholders have invested). Indeed, this measure has been strong in recent years but would likely weaken as a result of tighter restrictions, unless it raises the interest it charges on loans instead (which could in itself curb lending growth, impacting earnings potential).
Figure 6. Source: Company annual reports
Dividends
Stricter capital requirements could also have a significant impact on the banks' ability to grow, or even maintain their current dividend payout ratios. If the banks are forced to retain more capital on their books, that would mean they can afford to distribute less back to shareholders, at least in the short term.
In a chilling message delivered to investors last month, Westpac's deputy chief Phil Coffey warned that dividend payout ratios had peaked, citing the need to have "sufficient capital to back your activity as you look forward", as quoted by The Australian. Westpac and NAB were both forced to raise capital earlier this month and while Commonwealth Bank may avoid that necessity, don't be surprised if its dividend payout ratio is affected (notably, it declined from 75.4% in 2013 to 75.1% in 2014).
Furthermore, although the company has increased its dividend per share over the years, its yield has declined considerably as a result of its climbing share price. Based on its monthly average share price since July 2014, the stock is forecast to yield just 4.96% this financial year, down from a far more appealing 6.75% in 2012.
Figure 7. Source: Yahoo! Finance and CBA Annual Reports
Valuation & Conclusion
Commonwealth Bank's shares are trading at roughly $84 a unit, up nearly 250% since the beginning of 2009 or 365% when you include dividends and franking credits.
While the returns generated by Commonwealth Bank in recent years have been nothing short of spectacular; I believe it has now well and truly run its race. Of course, that's not to say I know for sure that it won't climb any higher than its current level (it very well could!), but in regards to the proper fundamentals, it is by no means looking cheap.
The fact is, bank profits are highly cyclical. While the bank has benefited from trends such as falling interest rates and record low bad debt charges, those forces appear to be running out of juice and could soon fall into reverse, dragging Commonwealth Bank's earnings down at the same time.
Although the bank might look cheap at first glance, given that it trades on a price/earnings multiple of 15x this year's forecast earnings, readers should not be fooled (lower-cast 'f'). A more accurate measure for determining a bank's value is the use of a price/book value, which measures the share price relative to the accountants' value of its assets, less liabilities. It trades on a p/b value of 2.7x.
The p/e ratio shows that it would take 15 years to earn back your investment based on today's price and earnings, and as I explained above there's no guarantee that it can actually sustain its current earnings rate. The bank's price-book ratio doesn't make the stock look cheap, either, given that investors should generally aim to purchase their bank shares when they're trading below parity with book value (that is at less than 1x). In fact, its p/b ratio actually shows that it is one of the most expensive bank stocks in the world.
With the stock's dividend yield having lost most of its appeal, together with the key risks now facing the banking industry, investors would be well advised to steer clear of Commonwealth Bank, at least until it declines in price considerably.
