The world's best investor, Warren Buffett, believes: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
For Australian banks, it couldn't be truer.
Over the past decade, investors have been lured in by the comparatively 'cheaper' shares of National Australia Bank Ltd (ASX: NAB) over its big four bank peers. Namely, Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group (ASX: ANZ).
Over the past 10 years, NAB's share price has appreciated just 19%, compared to the 43% return of the S&P/ASX 200 (INDEXASX: XJO). Commbank, Westpac and ANZ are up 146%, 82% and 63%, respectively.
Quality over quantity
Value investors know the best time to buy a company is when it's out of favour because a 'return to the mean' can be a powerful thing.
Indeed, NAB is the biggest Australian bank by assets but fourth largest by market capitalisation.
That means, it's NAB's profitability which is the problem.
Of the big four, it has the lowest net interest margin (1.94%), lowest cash return on equity (14.6%) and highest cost to income ratio (45.40%).
Much of its poor performance today is a legacy of yesterday's bad management.
Buffett: Turnaround's seldom turn
NAB's exposure in foreign markets, such as the United Kingdom and, to a lesser extent the US, continues to trouble it.
However its management is making strides in removing these assets from the balance sheet.
NAB's UK banking subsidiaries, which include the Clydesdale and Yorkshire brands, have been cutting costs by shutting branches and investing in technology.
It is also looking to divest more of its 'run off' portfolio which includes bad UK commercial property loans. These post-GFC loans have since been integrated into the main bank.
Just this week, NAB also announced the initial public offering of its US subsidiary, Great Western Bank, would be going ahead at an initial price between $21 and $24 per share. It will offload 16 million shares, or 27.6% of its holding.
Buy, Hold, or Sell?
Many investors have bought into NAB's seemingly cheap shares expecting a turnaround of its fortunes. Indeed, the forecast 6.2% fully franked dividend and price-book ratio of 1.77 is hard to ignore. However, despite its share price falling 9% since the beginning of September, I think NAB (and its peers) are still not cheap.
Using a modest average discount rate of 11% to reflect the inevitable rises in bad debt charges, interest rates and NAB's accident-prone history, I believe fair value for NAB shares would be between $26.00 and $28.
So if you want a solid dividend-paying stock idea to buy now, I suggest you look elsewhere…
