What to do with the Banks

Our first speaker has joined the call.

Let's welcome the Chief Investment Officer of Atlas Funds Management, Hugh Dye.

The Atlas High Income Property Fund aims to provide investors with income primarily through the acquisition of property securities, with an overlay of an active strategy of selling core options.

The Atlas Concentrated Australian Equity Portfolio is a separately managed account constructing a concentrated portfolio of 18 to 30 large-cap securities, a high-franket yield, and capital gains tax concessions.

If you have the question of what to do with the banks, Hugh has all the answers.

Welcome Hugh.

Hugh, good afternoon.

Well, it's been a what to do with the banks is one of the big questions facing institutional investors and retail investors alike.

They comprise around about 25 percent of the ASX 200 pay high, very high yields.

But I've also have a quite negative sentiment towards them.

So they look extremely cheap at the moment.

It's been an eventful couple of years for the banks.

So with each year assuming bringing another new negative thing with hundreds in the press, we're going to think that it's going to damage the banks.

So

2019, the big story was around neobanks, that they were going to take over the bank's margin, eat their lunch and sort of render their whole business model a bit outdated and a bit old.

That hasn't proved to happen with a range of the neobanks handing back their licenses.

Finally, it's just too hard to go up against the strong banking oligopoly.

And that's in the last few.

2020, we saw capital raisings from a range of the banks, NAB and Westpac,

And indeed, both NAB and Westpac stopped dividends.

So for income investors, that's pretty bad.

First time since 1893 that the banks have stopped paying dividends.

Then again, in 2021, we had APRA warning the banks about the impact of zero or even negative interest rates, which were forecast at the time and impact on their systems to handle this sort of very novel level of interest rates, which is unprecedented in 4000 years of human commerce.

This is quite comical sitting here in 2023 that

They're worried about sort of zero interest rates.

And then over the last sort of year, we've seen the RBA raise rates for 400 basis points from 0.10 basis points to 4.1 in 12 steps.

And that's the steepest rise since the late 80s.

And it's still still still flowing.

So currently the market's very negative.

There's a lot of negative sentiments towards the banks.

And whilst we see sort of bad debts, bad debts will rise there.

I think the banks are in a much better situation in 2023 than they were in 2007 to weather the storm.

So in terms of looking at the banks themselves, they're becoming increasingly more homogenous, but the way to think about it is Commonwealth Bank and Westpac have heavy weights towards retail banking, particularly mortgages.

Westpac's ANZ and National Trade Bank, much greater weight to business banks.

So historically, that means that Commonwealth Bank and Westpac have lower loan losses, people tend to pay off their mortgages, and high loan losses for the ANZ and NAB,

That's why losses are important.

Bad debts are quite important because they erode both the road capital and impacts the dividends paid to shareholders.

Macquarie Bank is increasingly becoming the fifth largest bank, getting very close to the market cap of ANZ at 66 billion.

Whilst they're growing in retail banking, they're more a global bank with global activities around the world.

So they're not quite as impacted as the same extent as Australia and the Australian banks on a recession.

Looking through this slide here, I think this is quite important.

So we look at the bad debts over the last sort of 40 years.

So with a lot of people, they're thinking that the bad debt cycle that we're facing in 2024 is going to look something similar to the GFC in 2008, 2009, or even the 1991 recession.

We take the view that that's far too pessimistic and the banks are a little bit differently structured.

using a playbook that it's going to be grim like it was during the GSC or very, very grim like in the early 1990s.

That's not quite the way how they are.

The banks are in a much stronger financial position in now due to some of their own moves into other moves that the APRA have made them do.

They're in a bit much better situation such that there's a reasonable chance they are going to surprise on the upside.

Overall, their books are a lot cleaner.

in 2023 than they were in previous cycles.

And that means much more focused on just bread and butter lending to small businesses and mortgages, less focus on corporate lending, which can be quite the result of large debts.

Also, a lot of them cleaned up some of their offshore ventures.

So in the previous cycles, we saw ANZ have heavy exposure to Asia.

NAB very famously had very exposure into northern England and Scotland, which caused which caused a lot of problems for them.

So generally, there are lots of the cleaner and they're much more focused to the Australian market.

And we view that that's going to result in much lower bad debts and surprising on the upside in terms of profits over the next year.

So looking at how what is that?

What are the banking sector look like in 2007 versus now?

So a key thing there

is they have a lot more capital now than they did going into the previous cycle.

So sitting here in 23, they've had roughly 12% of capital backing their loans.

And that's almost double what they were going to the previous rate tightening cycle in 2007.

Whilst a lot of the bank CEOs will claim that that's their own brilliance and how prudent they were, the realistically that is average drag, keep dragging them, kicking and screaming to raise more capital, to put them in a much more stable position, safer position going into the

the upcoming any tightening cycle.

So for a shareholder means you're you're much more safe in there.

There's more capital backing up those loans than you were looking back sort of 16 years ago.

Similarly, the way how banks fund their businesses are a lot more stable now than they were going to the GFC with much more the loan book being what they're lending being supported by deposits.

That's a much more stable source of funding rather than look at 16 years ago where

books were primarily funded by the wholesale markets, the wholesale markets.

That was work that's also not only is that more expensive, that money can go and it's much less stable, whereas right now today, they're in a much more stable position to fund their bad debts.

And that also results in sort of higher profit margins.

Furthermore, I mean, one of the key things around bad debts and also sort of profits being cut is unemployment.

It's when you think about it, it's not falling house prices that cause bad debts and cause bad debts for the banks.

It's the combination of falling house prices and unemployment sitting here.

We're at three, three and a half percent unemployment, pretty much the lowest in the last 20 or 30 years.

And that's very good for the banks and in particular bank shareholders in that people will service their mortgages, but perhaps may cut down on some discretionary spend from holiday.

So I don't know if you'd want to be owning a lot of flight center.

and discretionary spend there, but they'll service their mortgage whilst people still have a job.

So they're in a much more stable position there.

Also, something which is not really widely thought about is the big four, their market share has increased quite dramatically, using the previous crisis to expand.

So looking at 16 years ago, a range of their bigger competitors, for example, St. George or Bankwest, have now been gobbled up and subsumed into the big banks.

That puts them in an extraordinarily strong capital market position.

Also, we've seen a range of foreign banks lead Australia, just viewing it sort of too hard.

A great example of that is Citibank.

They sold their domestic banking franchise late last year to National Australia Bank, viewing the Australian market as just far too hard with the incumbents having far too much strong power.

So that puts them in a very good position.

We saw that in February when CBA came out with a fantastic result.

the treasurer talked about how sort of the Australian banks are far too strong and far too powerful and extract too many profits.

But then a mere three or four weeks later, when Silicon Valley Bank failed, we had the Republic Bank was subsumed into JP Morgan.

We had that same treasure congratulating the Australian banking system, how strong and profitable and powerful it is.

So it's one of the feature is whilst they have strong market share, they're also very well capitalized and in a much better situation than

European banks or American banking system.

Something we'd also like to look at here.

This is the we do the scorecard every result season and looked at.

This is the May scorecard for the banks as a couple of short months ago.

What was really clear all through that this is the banks are extremely profitable.

So running at we saw profits increase in dividends from double digits.

The highlight there was sort of Macquarie and CBA dividends up 20 percent earnings per share of quite strongly.

net interest margins expanding, that's the money they make over lending loans expanding.

Yet at the same time, we're seeing very sort of low, it's very cheap compared to the rest of the index.

So trading some arrangements banks, CBA is a bit more expensive than the others, they generally have much higher return on equity, but trading on a PE of roughly about 10 times currently, and with a sort of a forward yield in that six or 7%.

Based on our sort of working out, their yield is a lot more sustainable than people think.

But if you said the final thing, they're still a bit negative.

The market's still very not sure about the banks and they're still making, still assuming things are going to fall to bits and be very, very bad for them, very high, bad debts.

But we don't see based on looking at where they were in the past, these banks are in a much better situation and there's a strong reason why they're likely to sort of to outperform over there.

one of the big things which has been quite puzzling us and puzzling a lot of people who have been calling for a massive declines in the in retail sales and house price falls has been impacted immigration.

So after having sort of zero or very little immigration during Covid, that's bounced back very strongly.

2022 was a massive year for immigrant net immigration, did the greatest on the highest on record with four hundred thousand net markets coming in.

Similarly, two thousand twenty three is looking the same close to three hundred thousand.

A lot of these are skilled migrants coming in with lots of cash and wanting to build households.

And that's why we're seeing house prices, which if you'd asked me last September, given the fixed rate motive, we would have expected house prices to fall off quite dramatically.

Indeed, we've seen house prices rise over the last four months and also retail sales, which you probably expected them to be very, very grim at this stage with people refinancing mortgages and voyages going up.

they're actually still moving along.

And I think the big impact that there is this net increase in overseas migration coming into Australia, providing a lift for housing prices, the retail sales.

And that's a very good news for bank shareholders in that house prices are strong, the economy is looking a lot stronger than expected.

And we're likely to see a much better sort of financial results than people expect.

So pulling us all together, whilst the market is very negative towards the banks, they're in a much better shape than a lot of people think.

And if you look through the cycle of the Australian banking oligopoly, it's been very effective in maintaining profit margins and maintaining their profits throughout a range of cycle and seeing off a lot of issues.

We take the view that there's a very cheap sector and with the potential to dramatically outperform

over the next year as they reduce much lower bad debts than expected.

Higher profits because they're in a much stronger position than I think a lot of the market the market view them at and using the playbook from other tightening cycles or recessions from the example, the GFC or 1991.

That's going to give you a far too pessimistic outcome.

And we're looking forward to being sort of being pleasantly surprised by strong dividends and much better than expected earnings from Australia's banks.

Thank you here for the presentation and you certainly answer a lot of questions our investors might already have.

But I still have some questions for you.

In your opinion, what are the differences, if there's any, between the big five, I heard you talk about Macquarie Bank, the fifth bank, between the big five Australian banks?

Westpac and CBA look rather similar.

They're very heavily focused on domestic lending to mortgages, which is historically quite a low loan loss.

ANZ is much bigger in New Zealand, which has also been quite a profitable market.

They're the largest bank in New Zealand, with National Australia Bank very heavily focused towards business lending.

Business lending can be quite profitable at some times, but it's also a lot more competition.

Obviously, you can do a big line of 200 million, 300 million rather than 100 million dollar loans or 200, 300 loans per house.

It can be quite easy to process.

But historically, that actually results in higher loan losses and also lower margin because you're also competing with

big European banks and big sort of Japanese banks for that American banks for that same business.

Macquarie Bank has a smaller share.

They're around about 5% of the Australian market in terms of mortgages, but they're a global bank.

So whereas the big four Australian banks are increasingly Australian as I've talked about before, pulling back from overseas adventures, which have generally caused a lot of tears for shareholders.

Australian banks do very well at home.

They tend to do quite poorly offshore.

Macquarie Bank's an exception of that.

So they've got a big funds management business.

with assets under management of close to $800 billion, primarily in infrastructure, their commodities and global markets business, trading energy globally.

It's been a very, very strong sort of source of capital.

And then also their Macquarie Capital business, which is investment banking and IPOs.

Bit quiet at the moment, but it's generally proved quite sort of proper throughout the cycle.

The big four Australian banks generally are limited by Australian GDP growth, and it's very hard for them to gain market share because their competitors

overall roughly at the same cost of capital to lend a mortgage and they move their prices simultaneously.

So, yeah, there's fewer differences as compared to they were 10 to 15 years ago.

But yeah, so generally what we expect is low loan losses from the two mortgage banks based in Sydney, so CBA and Westpac, high loan losses from ANZ and National Australia Bank.

But then, as I mentioned a bit earlier, the books are a little bit cleaner than they were going into

last things with a lot of those more contentious developer loans being put onto private credit funds or second tier banks.

Well, the last question I have for you is, you know, from an investor perspective, one of the biggest concerns are banks' bad debts and the fixed rate clip.

So what does the future hold for bank bad debts?

Yeah, that's probably the biggest question that's been

that's been on all bank investors' minds.

We've been quite surprised at the strength of the economy and quite surprised at the lack of bad debts coming through.

Bad debts are very important because they impact banks' profitability, reduce their capital, and also ultimately the dividends paid to shareholders.

Our view is it's gonna be still very, very muted.

We're not gonna see bad debts spike to 100%, 1% of loans or even 75.

I think we're still gonna be,

I mean, increasing slightly, but nothing like the levels we've seen in previous cycles.

And the big fact of that is they're less corporate loans on the back on the back debts, more focus on mortgages and unemployment still very low.

So in that environment, people are saying it's not like the US where we have non-recourse lending.

If I stop paying my mortgage to Westpac, they will come after me to the ends of the earth.

I can't just send them back my keys.

So Australians, historically, they have a much more propensity to pay down mortgages, particularly in an environment where house prices haven't fallen.

In fact, they've been increasing over the last four months.

So in that environment, you're in positive equity territory.

There's no incentive to default on the loans.

The banks really don't want you to default on the loans because they don't want to take those properties on balance sheet.

They'd much prefer to either lengthen the term, work with you, move to an interest only rather than default on it.

And in the worst possible situation where you are defaulted, bank shareholders, unfortunately, it's very fortunate to say, are going to be quite well protected in that with property prices increasing at a loan value ratio of 80%, there's enough to cover that loan.

So very unpleasant for the people that do default, but it's probably not going to result in massive amounts of bad debt and erosion of capital for bank shareholders.

Yep.

Well, thank you, Hugh, and it's so great to see you for the presentation today.

All the best.