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2017 stock idea: Commonwealth Bank of Australia

Commonwealth Bank of Australia (ASX: CBA) shares had a lacklustre 2016, with the banking giant’s share price declining almost 8% year-to-date.

Is it time to buy Commonwealth Bank shares?

Source: Google Finance

Source: Google Finance


Year in Review

Following the announcement in late August of a 2% fall in profit for its 2016 financial year, Commonwealth Bank shares edged higher to their current price of approximately $78.80.

Although a few concerns surrounding profit margins and loan impairments began to arise, overall the result appeared a consistent one. In addition, the bank announced a dividend of $4.20 per share, in-line with last year’s payout.

Commonwealth Bank’s third quarter update was also more of the same, once again hinting that we have passed a low in the credit impairment cycle.

Rumbles emerging?

Under the hood of all large banks however lies a tangled web of assumptions, compromise and leverage, a lethal concoction if – or when – the banking cycle turns.

Ultimately, banks are not only cyclical but hypersensitive to cycles. Given the bank has around $13 of loans for every $1 of shareholder equity, you can quickly understand why it does not take much of a downturn in its loan book to hurt profits.

Fortunately, Commonwealth Bank has a reputation for relatively prudent lending standards, which provides the best insurance for any bank during a downturn. Compared to its global counterparts, such as Wells Fargo for example, Commonwealth Bank has a low level of funding from customer deposits, currently around 66%. However, its push into deposits is reassuring as we lead into 2017.

Specifically, some forecasters expect interest rates to rise either in 2017 or 2018. In the U.S., where Australian banks derive a lot of their ‘wholesale’ funding, debt is expected to get more expensive. Moreover, the US Dollar (USD) is forecast to remain strong. Therefore, banks which use more deposit funding (opposed to wholesale funding from overseas) could be insulated from rising costs and a squeeze on their lending margins.

Using customer deposits does one very important thing for a bank’s profit margins, it extends them. Versus the interest rates on loans, deposit rates usually take a little longer to push up — widening the margin. But not only that, given that banks lend much more money than they have in equity, usually for a very long time, the incremental gains can be significant. Ultimately, banks lend long and borrow short, in terms of the durations of their assets and liabilities, respectively.

To emphasise what a margin expansion can do, a 0.1% move in Commonwealth Bank’s net interest margin (NIM) could result in $800 million in additional interest income.

A double-edged sword on a tightrope

More goes into a sound investment case than a hypothetical tinkering of lending margins. Undoubtedly, the elephant in the room for bank shareholders is property prices. To use a poor analogy, the heat is certainly on in the kitchens of Melbourne and Sydney. Unfortunately, the banks can’t get out.

Like its peers, Commonwealth Bank’s margins are at the mercy of the property market. Prudent lending standards do not help a bank avoid a market crash. According to some however, the Government does.

The implicit guarantee that the Government provides to Australia’s banks, including Commonwealth Bank, is often used as an excuse by investors to remain heavily exposed to bank shares. If the government was ever forced to come to the rescue, however, I would be willing to bet that shareholders would be all but wiped out.

Foolish takeaway

Many analysts will tell you a rising interest rate environment is good for Commonwealth Bank shares and those of its peers. However, there is too much junk in its trunk to say in any absolute terms the bank will benefit because there are too many moving parts, such as a cooling property market and increasing regulation.

Ask your finance Professor and he will tell you that uncertainty is the definition of risk. Therefore, with so many moving parts and such uncertainty in the market, I would want to pay a lower price than $78.80 for a slice of Commonwealth Bank shares. Although its forecast 2017 dividend is appealing, I would hold off buying Commbank shares, for now.

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Motley Fool Contributor Owen Raszkiewicz owns shares of Wells Fargo. Owen welcomes feedback on Google+, LinkedIn or you can follow him on Twitter @ASXinvest.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Wells Fargo. Motley Fool contributor Owen Raszkiewicz has no position in any stocks mentioned. 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.