PM Capital: Don’t bank on the Big Four for ongoing returns

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Australian banks are sound businesses, but according to PM Capital they are currently fully valued and do not offer the same growth opportunities as offshore financial stocks.

Paul Moore, Chief Investment Officer of PM Capital, said that following their recent strong results, Australian banks are now trading on a hard to justify valuations and operational metrics when compared to their historical valuation and those of their international peers.

“There is no doubt that Australian banks are great businesses; they are a guaranteed oligopoly, they all produce the same product at the same price and if they were to ever get into trouble, the government is guaranteed to bail them out. That being said, they are well priced for that now and we don’t believe this is the place for new investment.”

Mr Moore said current valuations were not factoring in the significant risk of the Australian mortgage market.

“Because of the way risk rating works in the global capital system, home loans are seen as risk-free, so can be held in great quantities on the balance sheet. In terms of gross loans to equity, Australian banks are sitting at up to 8.4 times. The perception of home loans is that they are not problematic, but the reality is if we ever had an environment where home prices were to decline 20-30% on a permanent basis, there would be a significant issue.

“The sizable amount of leverage on the balance sheet from these loans would cause serious distress. Further to this point, there is an anomaly in Australia; the bank with the highest leverage has the highest P/E ratio.   This highlights that people are forgetting how balance sheets work and assuming home loans will be fine forever, which is exactly what happened in 2008 in the US, and look how that turned out.”

Looking offshore, Uday Cheruvu, PM Capital banking analyst, said the outlook for growth in US financials was superior to that of the Australian market.

“The S&P banking index is trading around a 50 per cent lag to the pre GFC peak of 115.  In contrast, the S&P 500 index is trading at the same level as the pre-GFC peak, 1500 versus 1500,” he said.

“We are also seeing economic fundamentals recover. Consumer borrowing growth has turned positive in the US, housing prices are the lowest they’ve been since 1987, whilst debt service levels are the best they’ve been since 1994.   The GFC brought significant consolidation and decreased competition in the banking sector, while US bank margins are almost double that of Australian banks.”

Mr Moore said that while offshore markets presented some strong opportunities, investors also needed to tolerate a level of risk.

“I would also remind investors that returns do not come without volatility, but that the stock market is far more volatile than the underlying businesses it represents.  In the last twelve months there have been two market corrections of approximately seven to nine per cent.  To us these represented good buying opportunities. PM Capital will continue to seek a good collection of businesses to own, which over the longer term, should deliver solid returns for our investors.”

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