In recent years, it seems, the words "dividend stock" have become synonymous with, "big bank".
And why shouldn't the big banks be the first point of call for investors seeking yield?
After all, they offer grossed-up payouts in excess of 7%, compared to term deposits of around 3.5%, and they have an implicit government guarantee. Meaning the government will come to the rescue if need be.
It is important to understand however that government intervention is likely in times of significant economic distress, but there's no guarantee your investment will perform as expected.
So whilst a dividend of 7% might look good, when coupled a share price drop of say 10%, it's certainly not that good.
The risk associated with investing in shares, as opposed to term deposits and savings accounts, forces investors to demand a higher return.
Unfortunately we, as individual investors, can't control the return. Share prices will rise and fall whether we like it or not. In fact, the only way we can improve our chances of success in the market is by actively reducing risk.
We do this by studying the business attached to the three letter stock code, its industry prospects and growth strategy. Then we determine fair value.
Finally, we wait until we can buy a parcel shares at a price below our fair value estimate.
Which bank stock should you buy?
When it comes to bank quality, Commonwealth Bank of Australia (ASX: CBA) is the clear winner in my opinion. This is evidenced by its superior profitability, efficiency, capital structure and historical shareholder returns. From a purely operational perspective, if I were looking for a safe investment, it would be my choice bank.
However, from a share market investor's point of view, Commbank is not cheap and should be kept on watchlists at today's prices. Indeed at $84.75, it trades significantly above my fair value estimate. Assuming annual dividends per share grow at around 5.2% over the next five years – in line with analyst forecasts and below its 10-year average of 6.9% – fair value is likely around $63 per share.
For growth, I believe Australia and New Zealand Banking Group (ASX: ANZ) is the superior stock pick. Whilst the other big banks are focused heavily on the local market, which is expected to be marred by higher unemployment and slowing economic growth in coming years, ANZ is busily growing in Asia, where it now draws 24% of revenues.
However, like CBA, ANZ shares don't come cheap. As I noted in this article, I believe fair value for ANZ shares lies around $30. Investors would want to buy at a price much lower than that.
I don't claim to be an expert across every aspect of each of the big banks' operations, nor does my bearish sentiment imply I believe they'll crash or fall anytime soon. However, bank stocks are cyclical and at today's prices none of the big four are priced to buy. Nevertheless when prices do drop, for safety and growth, Commbank and ANZ, respectively, are my choices.
Don't want to wait around for a great stock pick? See below…
