So now we know.
Prime Minister Scott Morrison has announced that he will release the report from the Royal Commission into Financial Services next Monday after the stock market closes.
It's a bold, but correct decision. In a parliamentary system where governments are allowed to sit on reports for days, weeks or months before releasing them, a (relatively) immediate release is important.
Of course, Commissioner Hayne will deliver it to the government this Friday… so they will have the weekend to prepare their response, and/or get ahead of the news by announcing new regulations over the weekend.
Or, as in the case of federal budgets, selectively leak the contents.
Such is politics. But back to the report.
At The Motley Fool, we're hopeful that the Royal Commission will throw the book at the banks. The evidence has left us in no doubt that the twin poisons of a poor culture and shockingly misaligned incentives have wreaked havoc, and a dose of salts is required for both.
We're looking forward to reading what Commissioner Hayne has to say.
And so, a few short market-days before the release, what should bank shareholders do? Is it a case of buying the rumour and selling the fact? Or getting out of Dodge early? Or neither?
There is no simple answer. We just don't know how scathing Commissioner Hayne will be, nor how PM Morrison or Treasurer Frydenberg will react. We don't know how the Opposition will treat the findings.
There's a decent chance that either or both major political parties correctly sniff the wind, and go even further than Commissioner Hayne suggests, lest either of them be seen to be too 'soft' on the banks.
Here's the rub for investors, though: it's not what the Commission, or the pollies, propose that counts. At least, not in isolation. What matters is what investors think will happen, in advance, compared to what the politicians actually do.
In this sense, it's a dry run for the upcoming earnings season.
Earnings season could well be renamed 'expectations season', because the market doesn't react to the earnings themselves. Let me explain.
Let's say Company A grows earnings at 15%. That's good, right? Well, yes… but if the market was expecting 25%, the shares are going to fall, and probably fall hard.
Company B, on the other hand, might have a shocker, with profit falling by 40%. So the shares will fall? Not so fast. If investors expected profits to fall by 60%, we'll likely see the share price jump.
Then there's Company C. It delivers 20% growth when the market was expecting only 15%. The shares rise, right? Not so fast. They actually fall 13%. Why? Because Company C told the market that trading conditions were tough in January and it expects profits to fall in the coming year.
As I said, Expectations Season.
And so, back to the banks.
CBA shares are down around 12% over the past 12 months. They're down almost 19% since May 2017.
NAB is down 16% and 28%, respectively.
I won't keep going… you get the idea.
(As an aside, we don't hear much from those people who told us — loudly and publicly — that we were mad to be bearish on the banks. Funny that.)
How much of that is due to the Royal Commission, and how much because of falling house prices and stalling credit growth? We can't know, of course — it's anyone's guess. We'll find out for sure next week, probably first thing Tuesday morning, when the market reacts.
If there's already enough doom and gloom factored in, share prices won't move. If there's too little, we'll see bank valuations fall. And if the market was too pessimistic, then bank shareholders will be a happy bunch.
What will happen? I don't know. Nor does anyone else, so ignore the talking heads who say they do.
What I do know is this: at least as things currently stand, little of the economic environment recommends buying or holding bank shares over the long term, if beating the market is your aim.
When asset prices fall and credit grows only slowly, how can bank profits meaningfully improve? Sure they can cut costs. We've heard recently that ATM numbers are being cut as people use less cash. And branches, mark my words, will be next. More back-office jobs will go, too.
But, as the saying goes, you can't cut your way to greatness.
Eventually, the remaining opportunities for cost-cutting will be few. And like any other business, if you're not growing the top line, bottom line growth is tough to deliver.
Can you see that changing any time soon? No, me neither.
If you're trying to beat the market, there are simply many better options available to you.
There is one reason to hold the banks, though — if you're looking for income from a diversified portfolio.
If you're at a stage in life where dividend income — and the attached franking credits — are important, then pure capital growth may not be as important to you. In that environment, banks are hard to go past — though their share of your portfolio should be kept to a conservative level.
After all, the current yields from the banks range between around 6% – 8%, and that's before franking. The dividends could be cut by 25% across the board, and they'd probably still deserve a spot in your portfolio.
(Some people will say that they can, instead, invest in a market-beating portfolio and sell off portions of their holdings to fund retirement. Also true. And I wouldn't argue against it. But not everyone wants to take that approach, which I also appreciate. Horses for courses.)
We run a portfolio, with $1 million of The Motley Fool's own money, called Everlasting Income, which employs that income-first dividend strategy. I don't think it's giving too much away to say we have one of the Big 4 and one regional bank in that portfolio. Combined, they're less than 7% of the portfolio — a level I'm comfortable with on behalf of the company and our members.
I'm not here to sell you that service, by the way, but often the best approach to explain a view is to illustrate it — in this case with real money.
We're not changing anything about those positions in advance of the Royal Commission, because we don't know what's in the report. Yes, we could sell in advance, but we might miss out on gains if it turns out the market was too pessimistic. We might also suffer losses if we don't sell, if the market wasn't pessimistic enough. But we can't know — and we have no interest in pure speculation.
Moreover, we've sized our positions appropriately, so that any change won't have a disproportionate impact on the portfolio. We may well make changes after the report is issued — up or down, depending on what the report says and how the market responds. But it's probably less likely than more.
I would feel very differently about the banks, were they 30%, 40% or 50% of that portfolio. I have long held the view that Australian investors were — and are — way too exposed to one sector.
They've felt pain, as a result, over the last 12 – 24 months.
There are obviously tax consequences to consider, but if a portfolio was more than, say, 15% – 20% banks, I'd be worried. I'd sell down, assuming the tax impact wasn't too onerous.
And here's what I'd do: I'd invest in companies that are likely to offer better returns, if beating the market is your aim. I'd invest in companies that don't put your portfolio at risk, by being exposed to the same or similar risks as a portfolio chock-full of banks.
If you're looking for income, there are some great alternatives that don't offer quite the same yield, but help diversify and de-risk an otherwise overly concentrated portfolio.
And I'd sleep a whole lot better.
We'll know more next Monday. We'll cover the Commission's report and the political response. And we'll tell you what we think you should do differently — if anything.
But I can make one prediction: we never say never, but I can't imagine us ever being comfortable with our members or readers having more than 20% of their portfolios exposed to one sector, banking or otherwise. It's just a risk you don't need to take.
Fool on!
Scott Phillips
Chief Investment Officer
Motley Fool Australia
