Australian investors appear to be taking full advantage of the recent slump in Commonwealth Bank of Australia's (ASX: CBA) share price, bidding the stock a remarkable 10.1% higher over the last fortnight.
Commonwealth Bank of Australia has been a key driving force behind the Australian sharemarket's recovery since the depths of the Global Financial Crisis, and shareholders who have held on for the journey have been well rewarded.
But while many investors believed it was destined to breach the $100 per share mark, it instead maxed out at $96.69 and subsequently plunged just over 18%, narrowly avoiding an official bear market (a fall of 20% or more). The stock hit a seven-month low of $79.19 on 10 June, and has since recovered considerably to trade at $87.19.
Source: CMC Markets
Indeed, some investors are hopeful that the bank can return to its recent high levels, generating a quick profit along the way, but I'm taking a different view.
In fact, I believe the bank is now a clear 'Sell'.
Commonwealth Bank is facing some enormous challenges which could threaten to derail the market's somewhat unreasonable expectations. The same could also be said for Westpac Banking Corp (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ) – each of which find themselves in similar predicaments.
Commonwealth Bank, Westpac and ANZ all hit all-time high prices in March and April this year, while NAB traded at its highest price since before the GFC. One of the key drivers behind their record-smashing rise was the low interest rate environment which turbocharged their profits and made their fully franked dividend yields all the more appealing.
Let's start with Commonwealth Bank's earnings. On a cash basis, earnings per share (EPS) has risen at a compound annual growth rate (CAGR) of 11.9% since 2009, from $3.056 per share to $5.359 per share in 2014. Meanwhile, net profit after tax (NPAT) on a "cash basis" has also nearly doubled, hitting a record $8.68 billion in 2014, while its return on equity (ROE) has remained above 18%, well above the ROE achieved by its major competitors.
Looking at dividends, Commonwealth Bank has had this covered as well. It distributed a total of $4.01 per share in 2014, which compared to the $2.28 paid in 2009 – a CAGR of just under 12%. Its dividend payout ratio has also consistently remained between 73% and 77% during that time.
Strong headwinds
The bank's incredible earnings growth has been achieved thanks to a number of factors. First and foremost, businesses and consumers have taken out greater loans thanks to the cheap debt on offer while loan impairment charges (i.e. bad debts) have fallen to a record low level as businesses scrap to lower their leverage, taking advantage of the low interest repayments. This can be seen in the chart below:
Source: Reserve Bank of Australia, CBA Annual Reports
Unfortunately, investors appear to be forgetting that these falling bad debt expenses are "pro-cyclical", meaning that while they have enhanced profits in recent periods, they could seriously dent earnings as they inevitably begin to rise once again.
At the same time, the profit that Commonwealth Bank makes on the loans that it writes, measured by its Net Interest Margins (NIM), is becoming increasingly thin as a result of intense competition within the sector for new home loan customers.
Investors also need to worry about Commonwealth Bank's heavy exposure to Australia's booming property market which the financial industry regulators – particularly the Reserve Bank of Australia and the Australian Prudential Regulation Authority (APRA) – are becoming increasingly concerned about. While Commonwealth Bank has benefited enormously from the boom itself, it could also be amongst the worst affected should the 'bubble' suddenly burst.
Finally, it's very likely that each of Australia's largest banks will be required to hold greater amounts of capital as a protection against a potential economic downturn. Westpac and NAB have already been forced to raise capital while there is also the threat that the banks could be forced to pump the breaks on their dividend payouts as a method to increase their safeguard. Should this occur, you can expect enormous backlash from the market.
A final word
The returns generated by Commonwealth Bank of Australia in recent years have been nothing short of spectacular, but I believe it has now well and truly run its race. Of course, that's not to say that it won't climb any higher in the near-term, but I believe investors who buy are taking an unnecessarily high level of risk for a small potential payoff.
As it stands, the stock trades on a price/earnings ratio of 15.6x forecast earnings and a price/book ratio of 2.9x (both well above their 10-year averages). Given that the stock has surged more than 10% from its low over the last fortnight, I believe investors should take advantage of the price being offered and look to put their money to work where much higher returns can potentially be achieved.
