One persistent question when investing in global equities is whether to focus on sectors or regions. The answer is, of course, it depends. At times valuation in some countries presents as an attractive opportunity, at other times its clear the thematic outlook for an industry drives the decision. Certain sectors are substantially more global than others – healthcare, consumer discretionary, energy and mining spring to mind. Others such as utilities, telco, REITs and consumer staples are often largely domestically orientated.
Financials form an interesting differentiated set. On one hand they are intensely internal to the country of listing, yet on the other increasingly beholden to global regulation and interest rate cycles. With the banking industry such a predominant part of most self-managed Australian equity portfolios focused on dividend distributions rather than the operating environment, global banks can provide an alternative source of return. Over the twelve months to end May Australian banks have had the lowest return compared to the banking sector in other major markets. What gives here? After all, ours did so well during the financial crisis, while the news on global banks is littered with billion dollar fines and bad debts.
There is a great diversity in what is lumped into banks - from what we know best, lending and deposit taking institutions, to pure investment banks which don’t do either, but rather participate in financial market activity. The sector is possibly the most complex and least uniform of equity segments requiring a fair amount of specialist knowledge.
In common however, has been a major shift in regulation which has required all these organisations to increase the amount of capital they hold, to sell assets and in many cases restrict some of their activities. This restructuring is to some extent still ongoing, particularly across Europe. Perversely therefore many of these organisations are judged to have significant upside in earnings and improving return on equity, in stark contrast to Australian banks trading at their peaks.
Globally valuations are typically based on return on equity and price to book, overriding the traditional P/E as banks represent leveraged asset pools rather than just operating earnings. Notably dividend yields are acknowledged but don’t drive the valuation. In selected cases some banks have been restricted in paying out dividends to satisfy their capital requirements, but increasingly more can elect distributions.
Will global banks then more closely resemble the Australian structure of predictable lending while maximising their return on equity? If that is the case, it will highlight that our banks trade on large relative premiums offering an opportunity for the global banks to close the gap. The key difference will then be the dividend yield. Essentially this is due to the payout ratio. Global banks rarely pay out more than 50% of their earnings in dividends – most are in the 30-40% range. Increasingly many supplement that with buybacks and in the US it is not uncommon for this to represent an additional 20-40% of payout. The flexibility of buybacks combined with dividends has much merit.
Therefore how should Australian investors view global banks within a portfolio?
- They diversify the risks –interest rate, capital structure, lending growth etc. They are likely to be desynchronised from ours and even out portfolio performance
- They are less reliant on mortgage growth; concentration risk in our banks is high with largely the same profile.
- They will not provide the same income stream, but can do better on capital growth (and remember you can realise capital)
On balance these stocks are much better done through a managed fund as we have observed major changes in the weighting to banks over time and very specific selections within the banks. The best can do extremely well if they can adapt to work within regulation and new digital financial options, while others will fall by the wayside - a true stock picking sector, unlike the relatively uniform approach to Australian banks.