Since we first started buying US bank stocks in early 2013, our favourite large cap bank, Wells Fargo (WFC US) has more than doubled in Australian dollar terms, and our favourite regional Bank of the Ozarks (OZRK US) is up 250%.
Our view then was that they would do much better than their equivalents in Australia, like Commonwealth (CBA AU) or Bank of Bendigo (BEN AU), which have risen just 16% and 9% respectively over the same period.
Some of this reflects currency gains, but mostly it is because the U.S. banks were cheaper and/or had more growth. Despite their stupendous outperformance, we believe this remains the case, and we still hold both stocks.
The U.S. banks were - and still are - better capitalised. This is a critical reason why we believe that the news this week of Westpac (WBC) raising new capital, and also tightening up on its lending margins for residential mortgages shows the U.S. banks are still better value, even if the Australian dollar doesn't weaken any further.
To put this in context, CBA is on a forward PE of 13.5x compared with Wells Fargo's 12.5x, and the price to book difference is 2.1x vs 1.5x. Some of this can be explained by CBA's higher expected ROE for the current financial year, 17% vs 12.5%. However Wells Fargo actually earns more on assets, 1.3% vs 1.1% and CBA only gets its higher ROE from higher leverage, which in turn reflects that it is more weakly capitalised than WFC which has an Equity to Assets Ratio of 9%, vs 6% for CBA. In other words, we can be very confident WFC won't have to raise new equity, and much less certain for Australian banks....
Another important point is that U.S. banks have a much more solid funding base than Australian banks, WFC for example only lends out $75 for every $100 of deposits it takes in. CBA by contrast lends out $120. This means that CBA depends on wholesale markets to fund the gap, and when times get tough as they did in the GFC, the cost of funding can rise sharply, and its availability can get tight.
Of course, the residual attraction for Australian investors to local banks is their much higher dividend yields, especially as these are franked. The dividend yield is 5.7% for CBA vs 2.8% for WFC. However this is purely because WFC pays out less than a third of its profits in dividends, while CBA pays out more than 75%. Again this is one of the reasons that CBA is more likely to have to dilute shareholders by raising more new capital than WFC, which is actually likely to buy back shares.
Then there is earnings growth. For the year ahead, WFC's expected EPS growth of 1.4% doesn't sound very exciting, but CBA's EPS is actually expected to decline by 1.4%. The difference is even starker when we look at long term growth expectations. Based on consensus estimates, Wells Fargo is expected to grow EPS by nearly 11% per year over the next 3-5 years, whereas CBA is expected to grow its earnings per share by just 3%.
The following table gives a snapshot of key financial data on our preferred US banks and their Australian comparators. We have colour formatted the cells so the “good” data in each comparison is in green and the “bad” data is in red.
In our view the difference looks even more exciting when you compare quality US regionals with Australian regional banks like Bendigo Bank. The good US regional banks are much more expensive in terms of price to book or price to earnings, but we believe it is thoroughly worth paying up.
Bank of the Ozarks, based in Bill Clinton's home town of Little Rock, Arkansas, for example, is much more strongly capitalised and more defensively funded that Bank of Bendigo, and will probably grow its earnings per share by over 33% this year, compared to expected 3% decline for Bank of Bendigo. Although there are no long term consensus estimates we would also expect to grow by between 15% and 20% a year for several years. Oher regional banks we like in the US include New York based Signature Bank, Washington DC based Eagle Bancorp, and South State, based in South Carolina
The final point to note is that with the RBA tipping Australian housing prices to fall, Australian banks are likely to face slower lending growth, and potential asset quality issues. By contrast US banks are far from facing a housing bubble, and while a few banks will be hit by some bad loans associated with the falling oil price, particularly in Texas, we also feel more confident about the risks associated with commercial lending there.
With WFC now down about 15% from its high, as a result of the current global market correction, some very long term investors may want to contact their advisers to discuss whether they should try and buy directly into what we believe will be short term dip.
For an individual investor buying direct, trying to time a WFC purchase this may of course depend on forming a view on when the US stock market and indeed the bank itself have bottomed.
Generally however we have preferred to reduce risk for investors in the Morphic Global Opportunities Fund by hedging out country and sector risk by buying the banks we like, and funding this by shorting US bank exchange trading funds. This works especially well for regional banks like OZRK, which can be volatile on their own, but much less so when ‘paired’ in this way, while still generating significant alpha.