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2013 has been a standout year for the Big 4 Australian Banks. The financial sector as a whole added a further 19.14% year to date on top of last year’s 21.7% capital gain (before dividends). These types of gains are reminiscent of bull market and booming economic growth periods and in fact the annual capital gains of 2012 and 2013 exceeding the average annual capital gains made during the strong 2004 to 2006 period. With these gains in mind, historically low interest rates and solid expectations that dividends will not only continue, but in fact grow into 2014, investor’s love affair with Australian Big 4 Banks is set to continue.
The latest round of earnings reports has highlighted average adjusted earnings per share growth of 7.8% and dividend yields of close to 6.0%. For many investors the 6% dividend yield, plus 100% franking credits, versus the dwindling term deposit rates on offer at the Banks themselves, has been the primary attraction to adding or becoming overweight Banking stocks in their portfolios. Throughout 2013 in particular, a lot of unused cash that had been sitting on the sidelines, has now moved back into the equity markets.
Savvy investors know there is a big difference between price and value. Valuation measures define for us as savvy investors, whether we are paying too much for a stock, or on the flip side, whether a share is trading at barging prices. They also give us a benchmark for comparing between stocks that have widely different prices, say Commonwealth Bank of Australia (ASX:CBA) ($76) and Australia and New Zealand Banking Group (ASX:ANZ) ($31.50).
We find that higher quality companies mostly trade at higher valuations due to the higher demand generated by investors. A quick glance into the history of banking stock valuations does highlight some interest points.
First of all, all 4 of the major Australian banks are trading at higher than their 10 year average P/E multiples. This means that on average, CBA for example trades at a stock price of 14.25 times its earnings. The fact that Banks are currently priced higher that this average is expected due to the higher than average demand we have seen for these stocks this year. But given these inflated prices, is there much more upside available for new investors, and when do current investors look to take profit?
Take for example a movement back to the above 10yr averages. Such a revaluation would cause a 14% correction on National Australia Bank Ltd (ASX:NAB) back to $28.92 (based on data from 5th Dec). This is not our expectations, however would not be out of the question from a value perspective, and therefore the risk needs to be considered.
Interest rates are at historic lows, and according to expectations, are current at the low end of the cycle range. Amongst economists, consensus expectations are for interest rates to actually move higher by the end of 2014. Under this environment and as economic growth in Australia starts to pickup, banking products like home and business loans will become more and more in demand. Therefore we expect profit margins may shrink while Banks compete for new business, but within a recovering economy and overall growing revenue pool. So as long as the Banks can keep their bad debts low (as they have done very well at this year), and focus on productivity improvements, we would expect above trend growth in earnings, and therefore dividends too. This is good news for investors.
So, with banking stocks expected to continue to generating shareholder wealth, but with stock prices at higher than ideal valuations, how does the prudent investor get involved in 2014?
Due to valuation risks, we can take a protected approach to trading banks in 2014. Specifically, by calculating the dividend yields and using this expected income to purchase Put protection, investors can go into 2014 with a level of capital protection, whilst still enjoying the upside of stock ownership.
Using CBA for example, during 2013 total dividends of $3.64 per share were on offer. Looking out to Dec 2014 Puts for protection, an investor could currently purchase $70 puts, for a value close to income from the dividend. Therefore your dividends pay for 70 Puts, and leaving approx $5 capital or 6.5% risk on the shares for all of 2014 exposure. This is before any increases in dividends are considered.
For many investors, the ability to continue holding Banking shares or become new shareholders with only 6.5% capital at risk is a savvy play. However also add to this the ability to sell Call options throughout the next 12 months and risk is reduced further. By Selling Call option at higher strikes for a low yield will really add up throughout the year. For example, the 78 Calls ($3 higher) for Feb, currently offer approx 75c or 1% of the stock value (as at 9th Dec). If this process could be repeated 6 times throughout the year, then an additional 6% gross income would be generated. This is what is known as a Protected Buy Write or Protected Covered Call.
Taking this approach provides capital protection, the ability to create extra income from your investment; all while gaining exposure to some of the best run Banks in the world!
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