Investing outside the Big Four Banks

Investors seeking undervalued banking stocks should look outside the big four banks, a new Morningstar report shows, with many smaller banks trading below their valuation.

Bank shares declined in the March quarter, dragged down by concerns that a banking rout in the US and Europe could become widespread.

But Morningstar analyst Nathan Zaia says Australia's highly regulated banking sector is in a strong position for the coming quarters.

But while bargains can be found among the nonmajor banks, Zaia says opportunities also still exist among Australia’s big four banks, which are set to benefit most from higher interest rates.

Smaller banks are cheaper

While the price of all ASX-listed bank shares declined in the March quarter, the nonmajor banks are currently screening cheaper than their big four counterparts.

Comparing the price-to-fair-value rating of nonmajor banks versus major banks, both groups have trended deeper into undervalued territory, but that trend is more pronounced among non-major banks.

Bendigo & Adelaide Bank (BEN) is down around 8% year-to-date, while other nonmajor banks—MyState (MYS) and Bank of Queensland (BOQ)—are both down around 7% each.

In comparison, the Commonwealth Bank (CBA), Westpac (WBC), NAB (NAB) and ANZ (ANZ) are down 2.7% on average.

As a result, Zaia says forward dividend yields look attractive for nonmajor banks.

“After resetting dividend payout ratios, we think dividends can be maintained and grow in line with earnings,” he says.

“Share price weakness in most of the nonmajor banks relative to the majors has pushed dividend yields to very attractive levels.”

An undervalued non-major bank

While Bendigo & Adelaide Bank, MyState and Bank of Queensland are all currently trading in 4-star territory, Zaia says MyState (MYS) is Morningstar’s top pick among the smaller banks.

“MyState Bank is our pick of the no-moat-rated nonmajor banks, trading at a material discount to our fair value estimate,” he says.

“MyState shares price in declining home loan balances and compressed margins, but we think earnings growth will be underpinned by the small lender taking market share.”

MyState may only command a 0.3% share of the Australian home loan market, but Zaia says the bank’s investment in its digital offerings and expanded sales team, has demonstrated an ability to profitably grow loans.

“In fiscal 2022, the bank grew home loan balances by more than 25%, over three-times faster than the market,” he says.

Big four banks to benefit most from higher interest rates

A key indicator of bank profitability is a lender’s net interest margin (NIM) - which measures the difference between the interest a lender receives (interest paid by borrowers on loans) and what it pays (interest paid to customers for their savings).

As interest rates rose, lenders were quick to pass on each hike in full to borrowers with a variable home loan, but only partially passed on the rate hikes to savers.

Zaia says this is where the big four banks are set to benefit more than smaller lenders from the higher interest rate environment, given they have access to a greater pool of this cheap source of funding - transaction accounts.

Together, the big four banks control around 75% of the retail lending and retail deposit markets.

Smaller banks, on the other hand, need to find a larger portion of funding through more-expensive wholesale markets.

Unlike the smaller banks, Commonwealth Bank, Westpac, NAB and ANZ all have a wide moat rating, which represents a sustainable competitive advantage.

A company with an economic moat is expected to be able to fend off competition and earn high returns on capital for either 10 years (in the case of a narrow-moat rating) or 20 years (in the case of a wide-moat rating).

Zaia says bank moats are typically down to two factors: cost advantages and switching costs.

“As competition for both loans and deposits are high in the sector, low costs are key to achieving excess returns,” he says.

“Higher rates have already begun to hamper nonmajor banks, which do not enjoy the same low-cost transaction and saving deposits as the major banks.”

2 undervalued major banks

For investors seeking the security and long-term advantage of a wide-moat bank, Zaia points towards Westpac (WPC) and ANZ (ANZ), which are both trading in 4-star, undervalued territory.

“As the second-largest lender in Australia, we remain confident the funding cost advantages wide-moat-rated Westpac Banking enjoys will see a return to strong profits and returns on equity over time.”

Zaia says the outlook for ANZ Group (ANZ) remains strong despite the bank’s market share of home loans shrinking recently amid increased margin pressure.

“We suspect shares do not factor in that rising cash rates help the bank's margins and process investments should make the wide-moat bank competitive again,” he says.

Morningstar latest “Australian Banks Industry Pulse” is available in full to Investor subscribers.