Why You Shouldn’t Fall in Love With Beautiful Bank Yields

Yesterday was a day dripping in symbolism as far as the Australian share market was concerned. The ASX200 pushed through the 5,000 mark (apparently some psychological barrier) buoyed by the half-yearly profit release of the nation’s, and, it seems, the world’s, greatest bank. Which bank, you ask…

Our largest and most celebrated bank, the Commonwealth Bank! If ever we’ve seen a contrarian sell signal it’s ding ding dinging here. All the commentary we read this morning positively gushed with praise for the bank. It can do nothing wrong. CEO Ian Narev, it seems, could sit back and put his feet up and the money would still gush in.

It’s an unwritten rule of the market that when everyone agrees things are great and can only get better, that the opposite happens. Those piling into CBA in a ‘search of yield’ are ignoring this longstanding rule.

Before you rush out and buy the world’s most expensive bank, have a think about the following stats from yesterday’s half-yearly profit release.

Profitability, as measured by return on equity, was a very strong 18%, but down from 19.2% on the same prior period. Asset growth was just 3%, reflecting a very low growth credit environment. The net interest margin (the difference between what the bank earns on its assets and what it pays on its liabilities) fell by 2 basis points over the past 12 months (but was up 4 basis points from 6 months ago). In other words, it’s not doing much.

While the much touted ‘Cash’ profit figure increased by 6%, ‘statuary’ profits, the actual profit number that counts for shareholders, nudged ahead by 1%.

The highlight was cost control, with the cost-to-income ratio falling 70 basis points. This metric is an important one for banks.

The biggest growth area for the bank came from ‘Trading Income’, up a whopping 84% to $443 million. The growth resulted from a ‘tightening of credit spreads’ (courtesy of increased credit market speculation) which apparently lowers derivative counterparty risk and delivers a valuation windfall to the bank.

The increase in trading income accounted for over 80% of the 6% growth in cash profits.

It’s also worth noting the dividend increase. This was largely a result of an increase to the payout ratio, which is a sign that CBA, and the banking sector in general, are moving into a lower growth environment.

It’s a view supported by the decline in ‘Banking Income’, as shown in Note 2 of the results release (to find this, you have to get past the press release, which clearly many commentators couldn’t manage to do in their rush to deadline).

In the six months to December 2011, total banking income was $21,551 billion. In the six months to December 2012, it was $19,900 billion. That’s an income decline of 7.6% in the core banking business. A decline in interest income — the bank’s bread and butter — was the reason for the fall.

So the share price soars and just about everyone hails the result as a strong one and can only see more blue sky ahead. Yet the data is not particularly robust.

The bottom line here is that CBA is simply a search for yield stock. Its share price rises because speculators are ignoring the major risk disparities between having your money in a bank, and having it invested in a banks’ equity base.

Banks are highly leveraged, highly risky companies. They do well with a tailwind but fall apart when a headwind develops.

So keep this in mind this Valentine’s Day if you find yourself falling in love with bank stocks and the beautiful yields they offer up.

Greg Canavan
for Markets and Money 

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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