FNArena’s Weekly Insights – March 22 2021
In this week’s Weekly Insights:
-Banks: Bonds & Yields Versus Targets & Valuations
-Investing In 2021: The World Upside Down
-Pharma & Biotechs in February
By Rudi Filapek-Vandyck, Editor FNArena
Banks: Bonds & Yields Versus Targets & Valuations
My update on Australian banks last week elicited a few questions from subscribers which can be split in two:
-why are banks back in favour when their businesses haven’t genuinely changed much?
-are banks truly ‘expensive’, even if we ignore the fact that analysts’ price targets can move higher later in the year?
My combined responses to these questions:
It does make a humongous difference whether banks are facing a recessionary environment or, as is the case in 2021, the tailwinds of an economic recovery.
In addition, the pricing of the bond market makes it infinitely easier for banks to lift their profit margin on loans. Specifically, when short-dated bond yields are near zero and longer-dated bonds are rising, approaching 2%, this makes making money from lending money a lot easier than when everything is priced within a narrow range.
Not surprisingly, rising bond yields have triggered a repricing of equities. Banks, previously “cheaply” priced being local and international share market laggards, have thus benefited from a re-rating. History shows cyclicals, including banks, enjoy their moment under the sun when the economic recession is in the backview mirror.
This is because share markets are always forward looking. They don’t care where profits and dividends come from (low base?) but focus solely on where both are heading. Markets also do not necessarily care about what comes next. Though it would appear the sector locally can now potentially look forward to 2-3 years of unexpected buoyancy after 5.5 years of (mostly) hardship.
It is the latter prospect that currently feeds into forecasts of higher dividends, plus extras, for the years ahead. Admittedly, if banks do not use this period to restructure and re-align with the many challenges that lay ahead, as I am sure many companies are not, then they will be facing the same quagmire all over again in a few years’ time.
Thus far, however, one can only conclude banks in Australia are trying to reinvent themselves to stay relevant in the New Age of disruption and technology. Witness how they are all selling off low yielding operations (asset management, insurance, etc) while investing in areas such as BNPL, while also seeking out younger and more flexible partners in business.
On top of all of the above comes the sharp difference in property market dynamics throughout Australia today, which cannot be underestimated in terms of how beneficial this is for the banks (and other parts of the Australian economy).
Inside a general context of rising bond yields and -potentially- an environment of higher inflation, it makes perfect sense for Australian banks to regain favour with investors. Financial reports and quarterly updates from the sector in February have vindicated the market’s newfound obsession.
With so many SMSFs and retirees continuing on the lookout for yield and income, it must also be noted forward dividend yields are again approaching 5% (4.5% for Commbank ((CBA)); this remains attractive for many.
But, as per always, banks are not without risk. Any interruption or slowing down in the economic healing process will weigh down share prices. And, of course, banks are still being penalised for breaching laws and all kinds of malpractices, while local authorities are no doubt working towards taming the animal spirits that currently push up house prices throughout Australia.
When it comes to putting a “valuation” on the sector…
While forward looking price-earnings ratios (PEs) might occasionally prove too optimistic, in particular at negative turning points, backward looking PEs don’t tell you anything about the future.
Pick your poison.
In the current context in which banking operations are recovering from last year’s short though deep recession, I’d easily say last year’s PEs are next to useless. You wouldn’t calculate dividend yield from last year’s payout, so why do it for EPS growth?