The recent failures of US banks, Silicon Valley Bank (SVB) and Signature Bank, have unnerved investors globally.
Meanwhile, many commentators and analysts are suggesting the golden years of Australian banks are over. The rationale behind such thinking has been driven by recent evidence that banks’ net interest margins, the difference between interest earned on a loan and the cost to fund the loan through deposits, have recently peaked.
In the mortgage loan market, competition has been intense for more than 12 months, driving headline housing
loan rates lower. Such behaviour has been compounded by several major banks offering ‘cash backs’ to
borrowers as incentives to take up a loan. Finally, competition for customer deposits have also risen and have
added further pressure to the level of profits earned by Australian banks.
Investors are not just asking if the golden years of banks are over, some are questioning if banks are even safe
for their deposits.
We believe the golden years for Australian banks passed years ago, not in recent months.
The key driver of profits, net interest margins, peaked more than two decades ago. Competition has steadily
eroded banks’ net interest margins from approximately 3 per cent in 2002 to under 2 per cent in 2023.
Yet there have been periodic opportunities to make substantial capital gains from investing in banks. Often these
opportunities are marked by significant exogenous shocks as the Global Financial Crisis in 2008/2009 and
COVID-19 in 2021. Outside of these periods banks tend to have utility-like features: they are mature, generate
reasonably strong cash flows, and relatively high dividend payout ratios.
But there is no doubt things have changed for banks and financials generally. This altered landscape for investing in financials requires investors to be more selective, and to pay more attention to things like industry structure and company management, which have greater influence on whether financial stocks succeed or fail as investments.
When considering financial stocks as investments, there are some important factors to consider:
Industry structure
Industry structure matters when investing in financials, and especially banks. The Australian finance and
insurance industry is a major backbone of the economy, accounting for $160 billion or 7.6 per cent of Australia’s Gross Value Added in 2022. The proportionate size of the sector is not too different to the USA’s approximate 8 per cent of GDP.
What sets Australia apart from many countries is the concentration of market share held by the largest institutions – the four major Australian banks dominate the banking sector and yield considerable sway in pricing of financial products. The mortgage loan competition we highlight above was led by the major banks, to the disadvantage of regional banks and non-bank financial institutions.
For this reason, Prime Value currently does not invest in regional banks such as Bendigo Bank and Bank of
Queensland, and we are cautious on smaller non-bank financial institutions such as Resimac Limited.
That is not to say that size is everything – financials with large balance sheets and lots of capital backing do not
qualify automatically as great investments. We believe investors need to be highly selective when investing in
financial stocks.
Diversity within the sector
In recent years, the financial sector’s diversity has grown substantially. In many countries, including Australia,
investors have a wide and growing choice of different business models. Note that companies are progressing at
different pace of growth.
Some are benefitting from short-term tailwinds, such as gaining market share in niche segments including
consumer or automotive loans, as larger banks exit the market. Others are benefitting from structural tailwinds
such as the shift of superannuation funds to independent platform providers such as Netwealth and HUB24, at the expense of legacy players such as AMP.
More recently, the traditional financial institution has been disrupted by nimbler, service orientated, technology
focussed players that typically rely on lower capital requirements – the fintech’s.
Return Dispersions
A returns analysis of the Australian financial sector highlights the dispersion of returns across subsectors of the
financial sector, and within those subsectors.
In the chart below, we have aggregated the return profiles (capital gains, or losses, including any dividends
earned) among 29 financial stocks listed on the ASX over the past five years to April 2023. We further calculated
the median returns of the stocks within the subsectors.
In the Platforms subsector, which comprises Netwealth, HUB24 and Praemium, the median returns over the five-
year period was 15% per annum. However, the dispersion of returns have been broad, between 1 per cent and 21 per cent per annum over the five-year period, suggesting significant opportunities for active stock selectors.
Insurance companies also show a huge dispersion of returns.
But insurance brokers (comprising AUB Group, Steadfast and PSI Insurance), on the other hand, showed very little dispersion in their returns, suggesting fewer opportunities for active investors. We observe that insurance brokers have posted the highest median return over the last five years across the financial sector. These businesses are subject to light regulation, do not require large capital backing, and stand out as essential services to their clients.
We further note that the returns dispersion of the large and regional Australian banks has been relatively low over the past five years. It suggests the sector is mature, and the lack of competitive advantages between banks.
Source: Prime Value Asset Management
Four rules of thumb
When investing in financials we use four rules of thumb: Seek out companies with sustainable competitive
advantages; excellent management; attractive long term growth opportunities; and reasonable valuations.
Some examples of stocks where this has played out over recent years include funds manager Pinnacle
Investment Management Group (Prime Value first invested in 2018), and Macquarie Group (Prime Value first
invested in 2015). Pinnacle Investment Management has an edge in funds distribution, which made it compelling.
Macquarie Group has shown significant management leadership, which has leveraged the group’s strength to
enhance its market position.
Finally, technological advancements are driving change in the financial industry. Tech giants, including Apple and
fintechs such as Square, are innovating for growth with the aim of attracting and retaining customers cheaper and faster compared to their incumbent counterparts. We believe it’s extremely difficult to predict the future financial industry with great certainty, and there are bound to be surprises – which reinforces the opportunities for active stock selection.
ST Wong is chief investment officer at Prime Value Asset Management.
