Australia's big four banks, including Commonwealth Bank of Australia (ASX: CBA), Australia and New Zealand Banking Group (ASX: ANZ), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC), dominate the local stock exchange.
Thanks to decades of house price growth and a well-regulated financial sector, each have grown profits phenomenally.
However with share prices in three of the majors at or near all-time highs, new investors have to question how much risk they're taking before committing to a purchase.
Record profits
Each of the big banks recently announced huge earnings increases for the first six months of 2014. Despite revenues falling by 3%, Commonwealth Bank's $4.268 billion half-year cash profit caught much of the market by surprise and catapulted its shares over $80.
Based on forecast FY14 earnings per share it would put Commonwealth Bank on a price-earnings ratio above 15. Higher than its 10-year annual average of just 13.
Aside the fact that none of big banks' shares are cheap, there's a number of alarming trends emerging in each of the Big 4 to consider.
First, the impact of low interest rates cannot be overlooked. With the cash rate stuck at 2.5%, demand for high-yielding dividend stocks has skyrocketed, enabling shares in the big four to reach new highs. For long-term investors, it's what happens when interest rates rise that's important.
Low interest rates also encourage investment in the Australian property market. As a result, house prices climb higher and homeowners will take on more debt while rates are so low. Existing mortgagees will be able to catch-up on payments and bad debts will drop. We've witnessed each of the big banks significantly reduce their amount of bad debts over the past few years – this has helped them grow earnings significantly.
Excluding the troubled National Australia Bank, each of the majors have reduced their bad and doubtful debts since the RBA began lowering interest rates in 2011. Once again, when interest rates rise this trend will likely reverse.
Second, competition from mortgage brokers and regional lenders has intensified. This has resulted in lower earnings power from each of the big banks. A number of financial metrics can be used to measure this including Net Interest Margins, cost to income ratios, and return on equity. All the major banks reported lower Net Interest Margins in their first-half results (compared to their respective prior reporting periods).
Last, the question has to be asked: Can Australia's house price growth continue? Sure, there's more international buyers and Self-Managed Superannuation Fund (SMSF) investors than there were a few years ago. But hoping that house prices will continue to climb at the same pace they have in the past two decades could prove to be foolish. A mining boom and rising house prices contributed significantly to the health of the Australian economy and the banks' share prices, but without these tailwinds earnings growth will likely come at greater cost and slower pace.
Buyer Beware
I'm not tipping an all-out collapse in bank stocks (or house prices), but investors need to know that none of them are cheap. However, the good news is there are plenty of opportunities to be had elsewhere…
