With last week’s announcement of the Royal Commission on the Australian financial sector, which will likely have an emphasis on the largest banks, we have opted to reduce our weighting to Australia. Specifically, in the Hamilton Capital Global Bank ETF (HBG), we recently reduced the Australian banks to under 5% (from ~9%), replacing them with U.S. banks.
In the Hamilton Capital Global Financials Yield ETF (HFY), we also recently reduced Australian banks and other financials to under 6% (from 15%) in favour of India (up 5%) and Europe (up 7%). These changes, combined with others in Canada and the U.S., also saw shifts on a sub-sector basis. For more on the changes to HFY, including the increased earnings growth, see today’s comment “HFY: Reducing REITs, Australia, Increasing Earnings Outlook”.
Returning to Australia… The Australian banks are an excellent group of companies that: (i) are domiciled in a country with very high GDP per capita with excellent/extremely consistent economic performance (high GDP growth/last recession in 1991); (ii) have mid-teens ROE, near the top globally among developed economies; (iii) retain some of the highest capital ratios in the world (~15% CET1 ratios, vs. Canadian banks at ~11%); and finally (iv) have very high and reliable dividend yields (between 7-9%, generally).
In a benign regulatory environment, the Australian banking sector can represent a very attractive risk/reward if it can produce 3-4% EPS growth supported by 7-9% dividend yields. The sector’s high and reliable dividend yields also provide powerful downside protection in periods of macro uncertainty, making Australian banks one of the lowest beta banking sectors globally.
This year started out with a benign regulatory environment and the Australian bank index was up notably in the first four months. However, it turned very negative in May with the surprise announcement of a bank levy on the 4 largest banks. Followed by negative headlines relating primarily to the country’s largest and most profitable bank (CBA) caused the Australian bank index to decline over 10% (excluding dividends) in 7 months with high volatility. This weak performance occurred despite 3 of the 4 large banks reporting very solid operating results in 2H17 (reported in late October/early November with the sector rallying ~2.8% in October).
Following the bank levy and correction, we expected headline and regulatory risk would fade, allowing multiples to drift higher/normalize, particularly on the back of the favourable 2H17 operating results. However, with its majority weakened by the recent citizenship fiasco (also unexpected), the federal government bowed to opposition pressure to launch a much more consequential Royal Commission.
In our view, while obviously difficult to measure, the announcement reduced the likelihood of any near-term recovery in price-to-earnings multiples.
Although the group is trading at discounted multiples (13% discount to 5 year P/E relative to all industrials; source: Macquarie), we believe it will be difficult for the banking sector to close this gap in the near-term. The sheer significance/scope length of Royal Commissions (i.e., often a year or longer; this one has a February 2019 deadline) will increase the risk of the sector absorbing higher expenses and other unforeseen negative regulatory consequences that could weigh on operating leverage (referred to as jaws).
Given the positive fiscal and monetary backdrop in the global financial sector currently, we believe that greater value lies elsewhere – for now – notwithstanding the very high quality of the Australian banks.
We will revisit our Australian exposures in the future as the regulatory situation evolves.
Note: Comments, charts and opinions offered in this commentary are produced by Hamilton Capital and are for information purposes only. They should not be considered as advice to purchase or to sell mentioned securities. Any information offered is believed to be accurate, but is not guaranteed.