This post is in response to a discussion with MikeMennell &...

This post is in response to a discussion with MikeMennell & Stefanis (started on ARP.AX thread) on the merits, or otherwise, of investing in the banking sector today.

MM/Stef,

Let me preface my discussion by recognising that the major four Australian banks are unequivocally powerful economic organisations, with tremendous market presence (it's virtually impossible to live in contemporary Australia without coming into contact with a bank on an almost daily basis).

Yet, despite this acknowledgement, as the title to this thread suggests, I am disinclined to own bank shares at their current valuations. The reason for my wariness of the banks can be summarised in the phrase that I coin "systematic deleveraging", meaning that after decades of "gearing up", the entire economic system - households, SMEs, corporations - is reducing its indebtedness, a major structural change that was precipitated by the GFC.

For banks, this is a huge earnings headwind, and one that will be with us for years to come. [Even if participants in the economic system somehow suddenly one day woke up and said, "yes, the debt party is on again...gimme a loan and let's rock 'n roll", the secular rationing of global credit today as a result of the GFC would not accommodate a return to the heady good old days of borrow-and-spend (in the case of households) or borrow-and-expand (in the case of companies).]

So, loan growth has definitively stalled, and is likely to remain in a stalled state for some time to come (for years, in my view, not just months). For context, household disposable incomes in Australia today are less today two-thirds of household debt. Two decades ago, household disposable income was twice the level of debt. Such is the magnitude of the over-extension.

With little doubt, therefore, banks' top lines are ex-growth. This is a vitally important consideration when it comes to defining Australian banks as investments (for me it is critical that I can fully dimension the definitional nature of prospective investments).

Additionally, unlike the Golden Age for banks (~1990s up and until the GFC) where the cost of funding for banks was relatively benign, post-GFC, wholesale funding has been repriced upwards in dramatic fashion and competition for deposits has intensified, placing pressure on bank NIMs, a further impediment to earnings growth.

Put simply, flat top-lines plus margin pressure suggests to me that strong EPS and DPs growth are unlikely to be generated during this new age of DE-LEVERAGING.

This is a vastly different proposition from the 1990s and 2000's up and until the GFC, when banks enjoyed periods of double digit EPS and DPS growth driven not only by strong, system-driven growth in their loan books, but also by expanding Net Interest Margins (NIM) when the world was awash with credit.

In other words, in my opinion, for the foreseeable future banks should be viewed as proxies for fixed income securities.

But this first-pass "fixed income security" definition needs some important refining, and that refinement involves the capital structure of banks:

Strong loan growth was not the only tailwind provided to bank earnings over the previous two decades. In a world where regulators badly under-gauged credit risk, capital adequacy standards were relaxed and banks were in fact able to accelerate their individual rates of loan growth faster than the systemic rate of growth, i.e., for a constant shareholder capital base, banks were able to accelerate the extension of their loan books. The result was accelerating EPS growth and increasing Return on Equity, which in turn facilitated strong DPS growth and share buyback opportunities (which, in turn, accelerated EPS and DPS growth even further).

Entering the GFC, banks had almost $20 of outstanding loans for every $1 of shareholders' funds. Today, as regulators and banks have tightened capital adequacy requirements, the leverage is a bit lower, but is still massive, at around 17x to 18x.

And this helps us refine our earlier definition of banks as investments: not only are they today fixed income proxies, but they are very highly leveraged ones, i.e., leveraged bonds!

Now, I don't know about most people, but I tend to have an aversion for debt, an aversion that borders on loathing. This means I don't even like companies gearing up just a little bit aggressively in order to pursue high-quality growth. But when a company needs to be geared to the tune of 1,800%(!!!), like banks do, simply to roughly maintain current levels of earnings and dividends, then it is a complete anathema to everything that I believe about investing prudently.

And the really scary thing for me is that I don't believe many private investors appreciate just how extensive and potentially dangerous this sort of leverage is...forget about REITS, toll roads or gas pipeline trusts....banks are the ultimate in acute levels of leverage!

Now I expect proponents of banking stocks to point out just how well banks' earnings have recovered subsequent to the GFC. The rebuttal to that is that that any earnings growth subsequent to the GFC has been attributable almost entirely to the accounting oddities such as as the reversal of bad provisions that were raised at the height of the GFC. Cash earnings have basically been static, and EPS has gone backwards due to the capital raisings that occurred in 2009 in order to bolster capital ratios.

[As an aside, I believe that the sector in the equity market that is most misunderstood by private investor is the banking sector. And the reason for that, I suspect, is that most private investors fondly recall the 15 years prior to the GFC when the planets were aligned perfectly (spectacular credit growth, low wholesale funding costs, and falling cost-to-income ratios) for the banks and they were able to grow cash EPS and DPS in double-digit terms. Few private investors, I feel, truly understand what it is they are really buying in the form of a bank stock, and few appreciate the fact that the favourable factors that drove bank outperformance historically are now absent, and are likely to remain so for a considerable period of time. From my considered observations the understanding gap between institutional investors and retail investors is very wide when it comes to banking stocks. The popular media has a lot to answer for in this regard: whenever the Big 4 banks report aggregate profits of $22bn, as they did this past financial year, the media facilitates all sorts of umbrage at this outcome, neglecting to point out that this has required about $150bn in shareholder capital and the deployment of almost two-and-a-half trillion dollars in loans!!! So Return on Equity is around 15% and Return on Assets for the banks is less than a mere 1%. Nothing supernormal about that sort of profitability. Pretty unremarkable, in fact.]

But now that I have defined banks as "highly leveraged bond proxies", I still need to look at what they are valued at before unilaterally decrying them as investments (for while they are what they are what they are in terms of riskiness, if they are cheap enough, the potential rewards might still justify the risk).

Given my view that any capital growth from the banks over the next 2 or 3 years will approximate EPS growth which I believe will be sluggish (5%pa to 7%pa) (any upwards re-rating of the sector is unlikely since bank stocks are already trading in line with their P/E history), meaning that the total return that I will get from holding bank shares over the next few years is likely to be the 5% to 7% capital appreciation, plus the dividend yield which ranges from 6.6% for ANZ and 7.0% for WBC.

So, in summary, my view is that total shareholder returns from the banking sector will be around 12%pa over the next few years. While this might sound reasonable, especially in a world of muted equity market returns (and I would gladly accept that sort of return on offer in most cases), on a risk-adjusted basis for the banks I don't feel that I am being adequately compensated for the risks inherent in the global financial system.

Note that I am not in the least concerned about the domestic threat of major residential mortgage defaults for the banks. While I think the property market will probably stagnate (I don't claim to be a specialist on the Australian property market; merely an interested observer) my intuitive view is that the structural undersupply of housing in Australia, low unemployment and low loan-to-value ratios on residential home loans, will provide a safety net for property values, if it is needed. And balance sheets of corporate Australia are in relatively good shape, due in part to reasonably conservative lending practices by the major banks, but also following the near $200bn in secondary equity issuances during and after the GFC, so business loans should remain trouble-free for the banks, especially as the economy continues to demonstrate resilience.

So it's not potential ambushes from a domestic source that concern me; rather it's the possible ructions on international capital markets and how those might adversely impact banks' wholesale funding. The banks are very susceptible to developments in international capital markets, and with the tsunami of refinancing of government debt in 2011, it is beyond my expertise set to form a view as to how that will play out.

Don't get me wrong, I don't absolutely hate the banks as investments. And I don?t see banks being offensively overvalued; I simply believe the global financial system is operating in unchartered waters, and I don't do "unchartered" very well. It makes me sleep uneasily.

Yes, they are omnipresent, economically-powerful entities, but there is much that lies outside the control of domestic banks.

When things are going in the right direction, leverage boosts returns; but when things go the wrong way, leverage becomes the enemy.

Call me chicken, but I simply detest leverage, even if it is in the hands of the gorilla banks who seem to call the shots.

Prudent Investing!

Cameron