When to and when not to own banks…
Banks are highly cyclical entities. They are leveraged into the credit cycle and amplify the growth or contraction in an economy.
Global banks have shown some interesting results over the last few years. Our take on what has happened is that the excessive credit growth leading up to the GFC made the banks look far more profitable than their long term growth could sustain.
At the top of a credit cycle, banks have low losses and high returns on elevated asset prices. When the cycle turns, banks start to write down assets to more realistic values. They also build up capital to buffer their capital ratio’s (often diluting shareholders in the process as per Citigroup). It is when the banks appear to have taken their medicine that they are the best time to buy. The market often sees this moment as a poor time to invest and the banks can trade at well below book value. Buffett recently stated that “banks are in the best shape I can remember”.
Banks can be in different cycles around the world. Currently banks in the US have taken their medicine and are reverting back to or are trading at just above book value on more rational asset values. In Australia, banks are trading at well over twice their book value on assets which are at the upper end of the credit cycle.
At Valor, we are not experts at predicting exactly when the cycle will end and prefer to follow Buffett’s advice in avoiding being “Cinderella at the ball” where everything will turn to “pumpkins and mice” at midnight, “only there are no clocks on the walls”.
In the short term we are likely to miss a few minutes of “one helluva party”. When participants are doing double shot vodka’s in markets, it is usually best to stay on the sidelines.
The standard view that banks in Australia have excellent capital ratios is dependent on the assets the capital ratios are derived from. Bethany Maclean writes and excellent article on this subject here.
Our core scenario is that property markets in Australia will have a very long period of anaemic growth. The probability of a sharp contraction is not zero and is somewhere in the ranges of 20% to 50%, depending on your views of how a China’s slowdown will flow through to Australia. In other words if you flip a coin, you are slightly more likely to be ok than not ok, but with only a 6% return for your coin flipping, I would avoid the game altogether. Our view is that the risks are greater than the rewards and we are avoiding leveraged institutions betting on higher credit growth.
We will buy Australian banks when they are trading at closer to their book value on assets which are closer to their long term averages. At this point, we will limit the amount we buy to around 10% of our portfolio due to their leveraged nature. There are plenty who disagree with our views, however I pity them if we ever have a downturn again in Australia. Betting that Australia will never have another recession is unlikely to prove to be a long term wealth plan.