According to Firetrail’s Blake Henricks, the trading multiples of Australian banks “are very hard to justify” as the fund manager continues to navigate an “unprecedented” market landscape.
In its latest monthly report in February, the Firetrail Australian High Conviction Fund, which holds a concentrated portfolio of approximately 25 companies including CSL and Santos, underperformed the benchmark by 2.64 per cent.
For the quarter, underperformance ticked up to some 5.75 per cent.
“In the last 20 years of investing, these last six months have been particularly disappointing,” admitted Henricks at a recent event in Sydney.
“When you run a concentrated strategy [like] the high conviction fund with just 25 stocks, there’s nowhere to hide, and what we’ve seen has been unprecedented.”
He observed that risk appears to be “very low at the moment”, however, the fund believes some of the valuation dislocations in the market today are on par with the valuation dislocations observed during the pandemic.
One factor that has cost the fund over the last six months, he said, has been the decision to avoid Australian banks.
As at 20 March 2024, the S&P/ASX 200 is up 7.8 per cent year to date. Since March last year, it has risen 20.32 per cent and notched almost 16 per cent in the last six months.
Explaining that Firetrail considers the operating environment of a company before turning to valuations, Henricks observed that big four player Commonwealth Bank (CBA) has been touted as a great, albeit, expensive company.
However, its earnings have grown at 0 per cent per annum for 10 years.
“The earnings have not grown. There have been dividends, but the earnings, the business, has not grown,” Henricks told audience members.
Meanwhile, the rest of the big four banks, namely NAB, ANZ, and Westpac, have underperformed CBA on an earnings basis, with earnings falling about 20 per cent in the last decade.
It was this that deterred the fund manager from the Australian banks, Henricks said.
“In 2000–08, credit growth through that period was averaging 7–12 per cent and earnings grew very strongly. Then, coming out of the GFC, you had competition shrink. If you remember, Commonwealth Bank was allowed to buy Bankwest – [it] would never happen today, that you would take a major competitor out. You also saw Westpac and St George merge, which again would never be allowed to happen today. So, you saw competition shrink and earnings grow,” he explained.
However, the last decade has seen a rise of competition in Australia’s banking sector, including a lift in the number of non-bank financial institutions and payments platforms like Block (formerly Square).
Even banks like Macquarie, which held some 0.5 per cent of the mortgage market share in 2013, have since grown to 5.5 per cent.
“There’s competition everywhere, so it should surprise none of us that earnings haven’t grown and are unlikely to grow in the future,” he said.
Turning to valuations, the investment executive argued they look “very stretched” for Australian banks.
“There’s been a lot of inquiries, like the supermarket inquiry – I’m going to call for a bank valuation inquiry because paying 22 times for CBA when the earnings haven’t grown for a decade, to us, is a bit much to take.
“It is worth paying a high multiple for earnings when the earnings are in the sink, maybe bad debts are really high. But no, bad debts are actually quite low […] in fact, the outlook for bad debts over the next three years from the market, and these are the best analysts publishing estimates, is at or below the lows of pre-COVID,” he said.
Given Australian banks are not underearning, the bank multiples are very hard for Firetrail to justify, he affirmed.
Earlier this year, VanEck observed that Australian banks, on a global basis, could be the most expensive in the developed world on a 12-month forward P/E and price-to-book basis.
“Despite some grim economic forecasts, the share prices of Australian banks have performed well over the past three months; CBA for example, recently hit an all-time high of $115.98 per share,” it stated.
Additionally, the rest of the big four have also continued to witness growth year-to-date with Westpac’s shares rising over 12 per cent to $25.90, NAB’s adding 9.69 per cent to $33.85, and ANZ’s 8.58 per cent to $28.22, as at 21 February 2024.
“This has been surprising, given banks typically underperform as the economy starts to slow and future rate-hike expectations fall. Valuations have now come to the fore,” VanEck said.
According to the investment manager, should valuations move to be in line with global valuations, and thus better reflect the economic outlook, it could disproportionately impact many Australian portfolios.
“Especially those that track or are benchmarked to the S&P/ASX 200, which we have noted before is concentrated to banks which make up over 20 per cent of the Australian benchmark index,” VanEck explained.
“Such sector bias makes sense if you are bullish on the sector but given the well-noted pressures on banks remain: margins are under pressure, the economic outlook is not conducive to growth and defaults are expected to rise, we think a more balanced approach to Australian equities may be prudent into 2024.”
VanEck also noted that while the prospects of a soft landing have improved, the market is pricing a “dream scenario” for the banks despite the risks of increased mortgage stress in a prolonged higher interest rate environment.
