The bull, the bear and the banks

About Latest Posts Scott PhillipsScott Phillips is The Motley Fool's Chief Investment Officer in Australia. He is Advisor of The …

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Another day, another $1.75 billion.

That seems to be the pattern for Australian banks this reporting season. Yesterday it was the Commonwealth Bank's (ASX: CBA) turn to make headlines with a 9.4% increase in cash profits for the most recent quarter.

CBA's result comes hot on the heels of recent results from ANZ (ASX: ANZ) whose full-year earnings were up 12%, Westpac (ASX: WBC), up 7% and NAB (ASX: NAB) with an increase of 19% in its full year cash profit.

Not just back to normal

With this sort of performance, you could be forgiven for thinking the banking world has resumed normal programming, and we could all go back to our overweight positions in Australia's big four banks as the bedrock of our share portfolios.

Unfortunately, buying (or holding) an investment simply because of past performance is dangerous at best, and disastrous at worst. Ask Eastman Kodak (NYSE: EK) shareholders how they've fared over the last 20 years, if you don't believe me!

Structured for success

Australia's major banks have a wonderful market structure. Over the past few decades, the fabled 'four pillars' policy has resulted in 4 massive banks, each with significant market shares.

They have been blessed with a very strong and growing Australian economy for decades, and have benefited greatly from carefree consumers who were prepared to put their lifestyles on credit, and their housing dreams on a 30-year variable loan.

Times were good, money came easily, and they took turns in opportunistically buying up their smaller competitors. Sure, the media took the occasional pot shot at bank profits and fees, but an otherwise happy Australian population didn't stay angry long, and the banks went back to their business.

The good times may be over…

Some of those benefits remain – most notably the Big 4's stranglehold on the Australian banking market – but many of the tailwinds that propelled banking profits ever higher have turned into headwinds.

Deleveraging consumers are now spending less than they are earning, and are paying down personal loans and credit card balances at a fair clip. The more austere spending environment has also spread to the housing market, where evidence is building of a slowdown in house price increases (and a decline in some areas).

For a banking sector reliant on credit growth to fuel profit growth, these headwinds are substantial.

If the GFC has taught investors anything, it's that knowing what is under the bonnet of their businesses is vital.

For banking stocks, this applies doubly, given the huge leverage inherent in even the most conservative banking operations, and the exposure banks have to both bad debts and the interconnectedness of the banking system.

If you don't think harm can come to our banks, never forget that Westpac wasn't all that far from collapse (or government intervention, which would have been substantively the same thing) in the early 90s. It might be true that our governments wouldn't let depositors lose money from a banking failure, but investors should be under no such illusions for their investments in those banks.

…but investors may still do well

On the local front, the bad debt provisions taken by our banks during the darkest days were reasonably modest, and they are being wound back as we speak, with bank CEOs taking the view that the worst has passed.

In addition, while economic activity is currently suppressed and credit growth is weak, only the most pessimistic (or optimistic, depending on your orientation) observer would doubt that consumers will – at some point – catch the spending bug again, with the resultant growth in banking profits. While the phrase 'irrational exuberance' has only relatively recently come to prominence, people have always swung between being irrationally optimistic and pessimistic, with short periods of balance in between.

Lastly, today's share prices for our big four banks are undemanding, to say the least. Trading at P/Es of between 10 –11.5 (but keeping this warning in mind) and sporting dividend yields in excess of 6.5% fully franked, there's a fair amount of downside protection built into current prices.

Foolish take-away

Of course, no price is cheap enough for a business that eventually goes broke, taking your investment with it. But equally, if the banks can keep their noses clean, costs under control and avoid destroying value in the quest for growth, investors at today's prices may do very nicely indeed.

One of the great things about investing is that no-one makes you bet on every option that comes across your desk or flashes up on your computer screen. There's no penalty for putting something in the 'too-hard' basket and moving to the next opportunity.

My portfolio is currently devoid of banking stocks, and is likely to stay that way in the medium term unless valuations become very compelling, simply because I'll focus on businesses I can more easily understand and analyse, and carry less inherent risk in their business model.

Are you looking for more quality stock ideas? Then click here to request a new free report titled The Motley Fool's Top Stock For 2012.

Scott doesn't own shares in any company mentioned in this article. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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