There are only a handful of companies in Australia that can make money the way the big four banks do. They have significant structural advantages over competitors including lower borrowing costs, wider networks with more branches, well-trusted brands, and lower per-customer operating costs due to economies of scale. Oh, and they also write around 85% of all new loans!
In recent years they have been aided by historically low interest rates pushing up demand for home loans, while also reducing bad debt expense (customers not being able to afford repayments). As a result, we've seen profits rise by upwards of 35% and share prices rise more than 50% since 2010. Dividends are also up over 25% for that period.
The banks are now above their historical price-to-earnings ratio average and expensive compared to their international peers. Analysts warn that the potential rise in bad debts, the legislative requirement to hold more capital from 2016, and past share price outperformance will halt bank profits and share price gains in their tracks.
I disagree. While bad debts will probably rise over time, interest rates are unlikely to rise enough any time soon to pressure the majority of households. Additionally, the big four banks are well placed to increase their capital allocation without adversely impacting their profits or share price. An example of this was Commonwealth Bank of Australia (ASX: CBA), who opted to issue new shares for dividend reinvestment plan subscribers, instead of purchasing shares on-market, as is usually the case.
Finally, despite strong gains in the share prices of the big four banks, their dividends remain some of the highest and most consistent on the ASX. While they are expensive relative to book value compared to their international peers, they're extremely cheap when compared on dividend yield. This is an important factor going forward with term deposit rates now hovering around 3% before tax.
Surely there are some risks?
Yes, of course! There are risks in any investment but I believe the risk of a housing collapse is low and it's unlikely there will be sweeping changes brought about by the Murray review into the financial system.
Foolish takeaway
A growing market, income-seeking investors, relatively low risk, and a dominant market share separate the big four banks from their smaller competitors. My personal favourite is Australia and New Zealand Banking Group (ASX: ANZ), as its growing exposure to Asia differentiates it from National Australia Bank Ltd (ASX: NAB), Westpac Banking Corp (ASX: WBC) and Commonwealth Bank.
