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5 reasons why you should avoid Commonwealth Bank of Australia

To buy, or not to buy?

That is the question on investors’ minds when it comes to Commonwealth Bank of Australia (ASX: CBA). The bank’s shares have erased all gains achieved over the last two-and-a-half years, having lost 25% of their market value since March.

As such, many investors would argue that now is a great time to stock up. This argument is largely based around the notion that the shares have performed well over the last two decades, so the same must hold true for the future.

To negate that argument, Australia has enjoyed 24 recession-free years. It’s been particularly strong over the last few years, where Commonwealth Bank, and each of its rivals, have enjoyed record low interest rates, low bad debt charges and a booming property market. Each of these factors have contributed to multiple periods of record earnings results, but they mightn’t be as prevalent in the years to come.

Here are five other reasons investors should steer clear of Commonwealth Bank:

1) Dividends

The bank’s generous dividend yield is a key attraction for local investors, who must otherwise accept the dismal returns offered by bonds or term deposits. Unfortunately, Citibank thinks that all four of our major banks could be forced to cut their dividends in three years’ time. I wouldn’t want to be relying on those dividends to retire on – nor would I want to be holding the shares if/when the banks pass on that bad news. Can you imagine the wave of SMSFs and retail investors selling out?

2) Regulation

One of the reasons why the banks could be forced to cut their dividends is tougher regulations in the sector. The Australian Prudential Regulation Authority, or APRA, is forcing the big banks, as well as Macquarie Group Ltd (ASX: MQG), to hold more capital in reserve in case of an economic downturn. This is designed to make them ‘unquestionably strong’, but will likely also impact their returns on equity (ROE) and could see them issue even more shares to raise funds. More shares means lower earnings per share, and likely lower dividends.

3) Valuation

As it stands, the Commonwealth Bank’s shares trade on a trailing price-book ratio of 2.2x with a price-earnings ratio of 13x. Although that is certainly more appealing now than it was five months ago, earnings growth across the sector will likely become harder to come by, meaning the bank isn’t necessarily ‘cheap’ it its current level. Both ratios are also looking through the rear-vision mirror and may not reflect the future.

4) Housing Market

Commonwealth Bank and Westpac Banking Corp (ASX: WBC) are the two banks most exposed to Australia’s booming property market. This has acted as a tailwind in recent years but also makes them riskier prospects should house prices suddenly take a turn for the worse.

5) Better Alternatives

Regardless of whether you think the bank’s shares are cheap right now, any upside potential seems somewhat limited. In my opinion, the potential gains to be made don’t yet outweigh the risk of holding them in case conditions do worsen. Given that the market has retreated roughly 16% since April, there are plenty of other alternatives which I believe are far more compelling today.

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Motley Fool contributor Ryan Newman has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. You can follow Ryan on Twitter @ASXvalueinvest.

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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