The S&P/ASX 200 (ASX: XJO) is trading near a 12-month low due to a slowdown in China, a global commodities rout and successive capital raisings by three of the big four banks, placing almost every sector in the red for the year to date. Whilst the former two problems are driven by weak economic fundamentals, a buying opportunity has presented itself within the banking sector because of the latter capital raisings. Australia and New Zealand Banking Group (ASX: ANZ) is, in my opinion, the best of the banks.
A stronger bank
Following the Murray Report published late last year, the Australian Prudential Regulation Authority (APRA) adopted several recommendations to make Australian banks "unquestionably strong". One of the key changes was to require Australian banks to increase their Common Equity Tier-1 (CET-1) ratios to above 10%. This change largely affects the big four banks as they typically have the lowest CET-1 ratios due to their market size. This is the reason why shares in ANZ, Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd. (ASX: NAB) and Westpac Banking Corp (ASX: WBC) have slumped.
The CET-1 ratio is the amount of capital a bank sets aside so that it can absorb losses. As the CET-1 ratio rises, banks are required to hold more 'undeployable capital', making their return on equity (ROE) decrease. The recent capital raising at ANZ, Commonwealth Bank and NAB is intended to achieve a higher CET-1 ratio for each of them. Accordingly, the proceeds from the respective capital raisings will be set aside in order to make each bank stronger.
The drop in share price, however, has not reflected this in my opinion. In the past, a bank's ROE has been a proxy for growth and the basis for valuation within the market. With the CET-1 rising, the market believes none of the big banks will be able to maintain their record profit growth and has punished bank shares indiscriminately. Of course, the discounted capital raisings have not helped the cause either, with share prices buckling under a wave of selling to "lock in profits" and freeing up cash to fund the offerings.
In my mind, the profit-taking should subside after each bank issues its new capital and market equilibrium returns. Therefore, the lingering concern is whether the increased CET-1 requirements will place a drag on earnings. I personally don't think they will.
Resilient earnings
In its third quarter update, ANZ reported cash profit growth of 4.3% but flagged a weak outlook for credit growth in Australia. However, it stated that its Asian expansion performed strongly, indicating resilience in earnings due to diversification.
Although results were below consensus estimates, the main negative was an uptick in ANZ's provision for bad debts (which the market now perceives as a systematic risk within the banking sector).
Whilst rising bad debts is a concern — if you recall that was the reason APRA asked the banks to raise their CET-1 — the recent capital raising should mitigate this risk by allowing ANZ to absorb any such losses.
A cheap price
At current prices, ANZ is the best value out of the big four, given it trades on an undemanding price-to-earnings ratio of 11.2. This compares to 12.4 for NAB and Westpac, and 14.2 for Commonwealth Bank, making ANZ the cheapest of the big four.
Even after the dilutive capital raising, ANZ should be able to maintain its dividend and grow it nominally in the current year, placing it on a forecast yield of 6.2% fully franked. This return should be sufficient to 'whet the appetites' of superannuation funds and entice them into buying for the income stream (once the angst over ANZ's capital raising dissipates).
Foolish takeaway
ANZ will be a stronger bank after its capital raising, with potential for earnings growth through its Asian expansion, and the ability to provide a solid dividend to support the share price. Therefore, the stock should recover in the coming months making it, in my opinion, a great buy at current prices.
