It is important for equity investors to understand the basis of the ‘big four’ banks’ strong performance, as this is useful in understanding future growth potential.
Australia’s big four banks (Commonwealth Bank, National Australia Bank (NAB), Westpac and ANZ) have experienced a monumental rise in share price due to the positive sentiment towards yielding stocks, but these were somewhat offset in recent months with the falling Australian dollar and offshore selling of Australian equities. However if we examine the big four banks as businesses, it is clear why they are considered the most profitable out of all developed nations.
So an investor might ask what the key fundamental drivers are that make the big four banks so attractive?
One factor is their prime investment grade AAA credit rating. During the Global Financial Crisis (GFC) in 2008 we witnessed numerous banks around the world either downgraded significantly or declared insolvent, yet our banks were among the few that maintained a top credit rating. This enabled them to keep pre-tax profits at a premium, putting them into the world’s top eight most profitable banks. As a result, foreign investors looking for stable equity positions during times of sentiment-driven volatility have seen the big four banks as extremely attractive investment options. The banks have also been bolstered to an extent by preferential Labor Government policies, coupled with a perception that they are “too big to fail”. The banks’ overall attractiveness to investors is apparent in the strong returns generated for shareholders. In the last year they have been able to achieve tremendous capital growth; Westpac leads the pack with 63% growth between its 52-week low and high while Commonwealth Bank sits at the bottom of the group with a healthy 39%. These figures are even more compelling when compared with the ASX 200 index that returned 29% within the same period.
Another factor contributing to the success of the big four is their domination of the Australian banking sector. Together they hold over three-quarters (77.6%) of the market while the bulk of the remainder is split between other domestic and foreign banks struggling to make a dent in the market. The monopolisation of the market by the big four enables them to sustain some of the largest net interest margins (NIMs) in the world. This is the difference between the banks’ funding costs and the interest rate imposed on consumers. Their decisions to not pass on all Reserve Bank interest rate cuts in full since late 2011 have led to high NIMs. This strategy has come under scrutiny by consumers due to higher variable home loan rates in comparison to the rates offered by smaller banks and credit unions. Our big four banks argue that this is necessary due to increasing costs of global funding. The fact that these funding costs are currently at their lowest levels since the GFC has led some to believe that the banks will be passing on rate cuts in full moving forward. This can be seen as a positive for shareholders as a large portion of profits are often transferred to shareholders through strong fully franked dividend yields.
Another driver of the big four’s profitability is their ability to consistently enact cost cutting measures, mainly through job cuts and streamlining internal processes. This means the banks have been able to negate the recent economic trend of costs growing at a faster rate than revenues.
Looking at future growth potential, although each of the big four banks make strong cases for significant expansion, the strategies implemented by NAB and ANZ are particularly important to address…
Excerpted from an article originally published in the Sep/Oct 2013 issue of Think & Grow Rich Inc. magazine. If you are a subscriber to Think & Grow Rich Inc. magazine, you will receive this article in your Sep/Oct 2013 issue of TGR. If you are not a subscriber, click here to subscribe.