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Why this leading fundie thinks ASX bank shares are undervalued

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ASX bank shares could be undervalued right now. That’s the message coming from leading fundie, Neil Margolis, from Merlon Capital.

Why is this fund manager bullish on the banks?

According to an article in yesterday’s Australian Financial Review (AFR), Mr Margolis sees strong upside potential in Aussie bank shares.

Much of the investment thesis is based around the impact of bad debts and forecast dividends in the short to medium term.

According to the article, Mr Margolis said, ‘if consensus estimates for bad debts of between $8 billion to $10 billion per bank over the next three years were correct, it would allow banks to make modest dividend payments’.

Introducing dividend estimates into the equation is a real game-changer. The Australian Prudential Regulation Authority (APRA) has been cracking down on bank dividends in 2020.

However, the banking regulator is now looking to revise its guidance on those dividend restrictions. That could be good news for ASX bank shares and their investors this year.

What does this mean for ASX bank shares?

I think much of the current pricing of ASX bank shares reflects a pessimistic view on dividends. 

However, the Commonwealth Bank of Australia (ASX: CBA) share price currently has a 5.8% dividend yield. Similarly, Westpac Banking Corp (ASX: WBC) shares are yielding a huge 9.7% today.

While I wouldn’t expect these yields to be maintained in the current climate, low bad debts and a modest dividend could definitely be good news.

That could mean ASX bank shares have been oversold at their current prices. The Commbank share price has fallen 7.2% in 2020 but is now outperforming the S&P/ASX 200 Index (ASX: XJO).

Westpac shares have fared worse, falling 25.5% to $18.01 per share. Interestingly, both bank shares are trading at a price-to-earnings (P/E) ratio of 13.5.

It’s worth noting that Mr Margolis wasn’t totally bullish on ASX bank shares, highlighting that a prolonged period of coronavirus restrictions could spell trouble for current valuations.

Prolonged restrictions could make current bad debt provisions insufficient and ‘that could mean capital raisings and zero dividends’.

Are there other ASX dividend shares to buy?

According to the AFR article, casino operator Star Entertainment Group Ltd (ASX: SGR) could be worth a look at $2.77 per share.

Star has similar upside exposure to economic recovery as the banks but with ‘more than $2 of property value’ per share to help protect investors against the downside.

Mr Margolis was less bullish on Telstra Corporation Ltd (ASX: TLS) shares. Significant headwinds including challenges presented by the NBN were cited as potential negatives for the Telstra dividend.

Foolish takeaway

It’s a very interesting time in the markets ahead of the August earnings season.

I often take market commentary with a grain of salt. However, it does give us investors some food for thought ahead of a big month for ASX shares.

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Motley Fool contributor Ken Hall has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Telstra Limited. 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 Scott Phillips.

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