Big, Bloated, and Ready to Fall?

Wednesday, 5th August, 2015
Melbourne, Australia
By Kris Sayce

  • Is this stock worth it?
  • Big and bloated
  • ‘Vulnerable to collapse’
  • The rise of the ‘Aussie shadow banks’

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Is it worth it?

Yesterday was a momentous occasion.

The winner of the race to $100 per share was…CSL Ltd [ASX:CSL].

It’s actually one of my favourite stocks. The trouble is, it’s the kind of stock that’s always going to look expensive.

It currently trades on a price to earnings ratio of 26-times earnings. And if you look at the price chart, when it gets into an uptrend, it has this habit of just grinding higher and higher without stopping.

Then it will crash, shaking a bunch of investors out, before beginning the grind higher again.

So, does the fact that a big Aussie stock now has a share price above $100 mean that the market is expensive and ready for a fall?

Not really. The stock price doesn’t mean half as much as the actual underlying value of the company compared to its earnings.

The same goes for the whole market.

Commonwealth Bank of Australia [ASX:CBA] currently trades for $87.40.

Is that a fair price? It’s about 10% below the record of $96.69 that it hit in March this year.

It’s currently paying a dividend of 4.7%. Is that a good dividend? It is when you compare it to AMP’s current term deposit offering of 2.9% per annum.

The difference is that, theoretically, the government guarantees the return of your term deposit. The government doesn’t directly guarantee the dividend from Commonwealth Bank.

Furthermore, for those investors who bought CBA shares at $96 in March, if the shares just float around the current level, it will take them more than two years to break even on the trade…assuming CBA maintains its dividend.

For many investors, that just hasn’t seemed like a risk worth taking. My old pal and colleague Vern Gowdie is one of them.

Vern has long advised anyone who will listen to stay out of the stock market. He agrees that dividends offer a better return than boring old cash, but he doesn’t view an extra two percentage points as being a worthwhile risk, compared to what you could lose if stocks fall.

Speaking of falling stocks and Commonwealth Bank, could Australia’s biggest company by stock market capitalisation be in for a spot of trouble…?

Big and bloated

Commonwealth Bank’s market cap is $143.3 billion. In terms of market cap, it’s 30% bigger than the ASX’s second biggest company, Westpac Banking Corporation [ASX:WBC].

Any guesses which companies make up the third and fourth spots on the ASX?

You go it. Australia & New Zealand Banking Group Ltd [ASX:ANZ] and National Australia Bank Ltd [ASX:NAB], in that order.

In fact, the combined market cap of the four banks now accounts for 23.9% of the ASX’s entire market value.

If you were in any doubt about the lopsided nature of the Aussie economy towards banking and housing, this is it.

Should that be a troubling sign? Perhaps.

It’s worth noting that in the first quarter of 2007, just before the market peaked, three of the world’s top 10 stocks were banking stocks:

  • Citigroup [NYSE:C] — market cap US$252.8 billion
  • Bank of America [NYSE:BAC] — market cap US$228.2 billion
  • Industrial & Commercial Bank of China [HKG:1398] — US$224.8 billion

By the first quarter of 2009, the only bank still on the list was ICBC. The American banks had shrunk from view.

Even today, more than eight years after being fixtures in the world’s top 10, the US banks haven’t returned to their previous high. Citigroup now has a market cap of US$177, while Bank of America has a market cap of US$186 billion.

(Incidentally, Apple [NASDAQ:AAPL] and Microsoft [NASDAQ:MSFT] are now the world’s two biggest companies, with Google [NASDAQ:GOOG] the fifth biggest. Maybe this is a sign to short-sell big tech stocks.)

The point here is that when big and bloated industries take a fall, it can take a long time for them to recover.

For many, it’s hard to imagine an Aussie bank collapsing. After all, Australia is different…we have the ‘Four Pillars’ policy and an eagle-eyed banking regulator in APRA.

But don’t get too comfortable in that view. Big and unexpected things can happen.

Earlier I asked if the CBA’s 4.7% dividend yield was good. As I say, compared to a term deposit it’s good. As long as the Reserve Bank of Australia keeps interest rates low, that should support bank share prices, right?

You’d think so. But what if the banks’ revenue and profits start to plateau? What if the banks can’t increase dividends anymore?

What if investors decide to ditch the banks because they’re no longer offering the same dividend growth that they offered in the past?

Those are all the things that investors need to bear in mind.

Not to mention the potential for an increase in bad debts or a slowing property market to provide further problems for the banks.

‘Vulnerable to collapse’

Our income investing guru, Matt Hibbard, sent this news story from the Australian my way this morning:

The Commonwealth Bank of Australia is most at risk from a regional house price crash in Western Australia, says CLSA banking analyst Brian Johnson, as slow population growth, higher home loan rates and an oncoming housing surplus leave the state’s property market vulnerable to a collapse.

The Commonwealth Bank is the most vulnerable of the major lenders to a housing price correction on the west coast, thanks to its Bankwest business, which CBA acquired in 2008, Mr Johnson estimates.

I’ve gotten it wrong on Aussie housing before. In 2008 and 2009 I forecast that Aussie house prices could fall 40% nationwide.

While they did fall by that amount in some ‘hot’ markets such as the Gold Coast and parts of Western Australia, the biggest markets, Melbourne and Sydney, survived relatively unscathed.

But how long can that last?

By any measure, Aussie house prices are high. If I’m right about the stock market crashing this October, and a recession potentially hitting Australia this year, is it really possible for Aussie house prices to keep going up?

We’ll see. CLSA’s Brian Johnson doesn’t seem to think so.

The rise of the Aussie ‘shadow banks’

According to the Financial Times back in May:

Non-bank lenders have overtaken US banks to grab a record slice of government-backed mortgages, after regulatory curbs on risk-taking and billions of dollars in fines forced mainstream providers to retreat from the $9.8tn home loan market.

So-called shadow banks such as Quicken Loans, PHH and accounted for 53 per cent of government-backed mortgages originated in April — almost double their share in April 2013.

It’s a timely reminder of how non-bank lenders grew in size and influence during the 1990s and 2000s here in Australia.

And last week, non-bank lender Pepper Group Ltd [ASX:PEP] listed on the ASX with a market cap of $607 million. It’s just small-fry, compared to the big Aussie banks.

But, it’s a growing business. In 2014 Pepper Group had revenue of $423 million, and had a loan book of $3.9 billion. It’s able to finance its loans through $4.2 billion of debt.

Could this be similar to the rise of Aussie Home Loans and Wizard Home Loans more than a decade ago?

I will admit that it’s funny how non-bank lenders now have the more sinister label of ‘shadow bank’. I can only think that the banking industry invented that term as a way to denigrate the competition.

My colleague Callum Newman, who edits the Cycles, Trends & Forecasts newsletter, has followed this story of non-bank lenders (or should I say ‘scary shadow banks’) and the housing market for some time, particularly in the context of the US.

Callum will fill you in with more details in tomorrow’s Port Phillip Insider, when he takes the reins as guest editor for the day.

The maths behind the market

Speaking of Cycles, Trends & Forecasts, the guys who run that service asks, ‘Does 18 = 14 + 4 predict literally everything in the asset markets?

It’s an odd question. But it’s a stunning answer. Go here for details.


Kris [+]