Australia’s banks may not exactly be endearing themselves to politicians and mortgage-holders when it comes to passing on official interest rate reductions. It’s a different story, however, when it comes to paying profits to investors in the form of tax-enhanced dividends.
Buy their shares not their products
As profit and tax-effective dividend income payers, the major Australian banks are not only among the best sources of income in the local sharemarket, but in the climate of falling interest rates they represent some of the very best income investments in the wider market.
As a consequence they have been among the sharemarket’s most sought-after investments.
With net dividend yields that currently range from 6 to 8 per cent and gross up to 8 to 11 per cent when 100 per cent dividend imputation franking credits are added, banks – especially the big four: the Commonwealth, ANZ, National Australia Bank and Westpac– have been at the forefront whenever the local market has shown promise.
The demand for bank shares from investors is reflected in the surging share prices of the biggest banks over the past year, ranging from between 15 per cent to nearly 30 per cent.
Although they haven’t yet recovered to the prices levels they reached five years ago at the peak of the boom that preceded the 2008-09 global financial crisis, the Australian banking sector has been very impressive in other ways, says John Abernethy, the chief investment officer at Clime Asset Management.
In terms of price recovery, Commonwealth, which hit $58 in August, has come close to its November 2007 peak of $62. Others, such as Westpac and ANZ, are within 20 per cent of their price peaks, while NAB, Bendigo and Adelaide and Bank of Queensland are 40 to 60 per cent behind. The five-year share price changes and five-year annual investment returns illustrate this.
That said, Abernethy has observed that the $400 billion market value of the Australian banking sector now exceeds that of all the banks in the euro zone. More significant than this is the profitability of Australian banks. They are among the most profitable in the world, whereas many European banks are technically insolvent, which is why they require bailouts.
Australian banks, says Abernethy, also represent an extraordinary 30 per cent of the capitalisation of the whole Australian sharemarket. Investors and retirees need to understand the consequences of this when it comes to the potential any bank investments they own have to deliver a return in their portfolios.
Where the strength lies in Australian banks for investors is in their profitability and scope to pay improving dividend income.
While there are sharemarket analysts such as Elio D’Amato of Lincoln Indicators who believe bank shares are currently trading at or above the price value their profits suggest, Abernethy reckons they deserve a premium because of their dividends, which not only look safe but, even better, are likely to go up.
At least three of the big four – Commonwealth, ANZ and Westpac – have already beaten their pre-GFC dividend payouts. Furthermore, those banks that are due to report final half-yearly results later this month are showing every sign of continuing this trend.
Abernethy reckons Westpac, for instance, is expected to pay an 84¢ final half dividend in November, up from last year’s final 80¢. This will mean its total dividend for the year is likely to be $1.66 compared with the previous year’s $1.56, a 6.5 per cent improvement.
But more impressively, this is 14 per cent above the 2008, pre-GFC, fully franked dividend of $1.42. The GFC, says Abernethy, made an impact on dividends during the following year, 2009, when Westpac’s total year payout, for example, fell 18 per cent to $1.16.
Commonwealth Bank, which reported its final 2012 dividend in August, has already impressed with a 4 per cent better total dividend of $3.34 compared with the previous year. This was 25 per cent better than the pre-GFC dividend of $2 in 2009.
Even better than before
So, does the fact that analysts think many bank shares are trading at value or higher make them attractive for new investors? Both Abernethy and D’Amato believe they are because of their profit and franked dividend potential.
While his analysis has the major banks rising in value by about 10 per cent, Abernethy reckons this does not overvalue them on an historical basis. The tables show three values for bank shares. As well as the Clime and Lincoln views there are the consensus forecasts of major research brokers compiled by Thomson Reuters.
For investors attracted to banks, Abernethy suggests an old rule of thumb for bank investing, which is to look for a 10 per cent gain plus dividend imputation franking credits, which suggests buying the shares for at least three dividends. The basis of this strategy, he says, is that if the share price holds its value over this period, the dividend alone will give investors the return they want from an equity investment.
The prospects of bank shares holding their value will be helped by expected stable earnings, says D’Amato. They will also be assisted by the fact that banks traditionally pay out a decent proportion of their profits as dividends. For investors wishing to better understand this aspect of share investing a measure to watch is the dividend cover ratio.
Dividend cover reflects a company’s ability to maintain its dividend. The ratio is calculated by dividing the annual dividend in cents per share into after-tax cents per share profit. For example, Commonwealth Bank’s most recent $3.34 dividend divided into its $4.34 profit per share gives a dividend ratio of about 1.3 times.
With dividend cover, the higher the ratio the better a company’s ability to maintain income payments is considered to be. As a general guide, a dividend cover greater than 1.7 is deemed to mean dividends can be sustained at current levels. That said, this is just a statistical measure that can be influenced by either profits or dividend policy.