EDITED TRANSCRIPT
Lukasz de Pourbaix (LDP): We'll be talking about a stock that is loved by many and hated by many - CBA. CBA has been a stellar performer over the last four months. I believe it's generated over 40% returns including dividends over the last 12 months. A great performer and a great outcome for those people that have held that stock. I know it is a stock that both of you do like. What has been some of the key drivers of that performance?
Zara Lyons (ZL): The key thing initially has been that banks generally have rallied when you have an RBA rate cutting cycle. That's because lower interest rates help stimulate credit growth as well as improve the borrowing outcomes of customers and improve their ability to repay the existing debts. So, you see a more benign credit cycle. We did see that play out through the year.
In addition, there are some nuances for CBA, aside from having very strong operations. It has 34% share of Australians as the main financial institution, which is a tremendous franchise advantage scale advantage, which helps them defray costs across a much broader customer base. But setting that to one side, they've executed very well over the years, paid out more capital in terms of capital management issued fewer shares than the competition. That's created a growing premium valuation premium gap to its major listed banking peers.
The other factors are technical things. In 1991, when CBA floated, it was around $5.40. If you do the math on that, it's probably up 30 times now. That is a genuine friction for the retail shareholders to sell and incur capital gains tax. Now, in terms of composition of CBAs shareholder base, when it was listed, I think about 56% of the share that was allocated to retail shareholders. That has subsequently reduced over the intervening period and now it's around 47%. Why am I saying that? Because when you put aside the index funds, which are about 30% of the shareholding and then other sort of sovereign funds and so on, there's a fairly small amount of active institutional investors. It's less than 10% of the shareholder registry that can buy and sell those shares, which is quite different to the other listed major bank peers. Or even if you look at the index more broadly, the ASX 200 index, it's about 30% of the index is held by retail shareholders. That creates a technical illiquidity in CBA as a genuine friction for selling.
Other factors have been the weight of money argument. Firstly, there's the index leadership. About 12 months ago, CBA became the first the leader in the ASX 200 index and took that mantle from BHP, which had had lost its number one leadership because of iron ore and commodity prices weakness. That was the first time that CBA has been the leader of the ASX 200 since 2016. That's been a long time between drinks. But in June, about 12 and a half percent of the index weight was CBA. So that's when you saw that real momentum squeeze, pushing the share price up to around $191, I think towards the end of June.
We've seen the Australian super funds getting larger, the super guarantee contribution increasing in a staged effect over the last five years. In July it went up to 12% of the annual payroll. The Australian super funds tend to exhibit a large Australian domestic home bias relative to other funds globally. The reasons for this are that we do have good corporate governance, great dividends, franked dividends, so there's tax advantages there. The confluence of all those factors, I think, have been very supportive to CBA and frankly they just haven't disappointed in terms of execution. They were one of the only banks that were having earnings growth and earnings upgrades through consensus upgrades over the last 12 months. That's been really positive relative to the peers.
In a nutshell, these are the reasons why CBA has outperformed peers. What we're seeing now is that usually, because CBA is off cycle reporting with the other major banks, they'll report in November, and you do tend to see a little bit of a flow out of CBA and into the other banks around this time because of positioning for dividend flow. That's a fact that has been around for a number of years. What we see conversely back after the other banks reported in May, then you see a bit of a flow back into CBA. So we do see that phenomenon happening a little bit as well.
LDP: That's very insightful because I didn't appreciate to what degree you look at the fundamental strength, but also these technical factors which certainly can impact the direction of share prices. We understand what's driven the performance of the last four months, so on a forward-looking basis, why do you like CBA why do you continue to hold it?
Because one of the obvious questions is ‘how do you marry the quality of the company with the price of the company?’ As the price has gone up and as we've had this strong performance, obviously you've seen price to earnings multiple go up as well. A lot of investors are in this conundrum of saying, ‘we like the growth, but the price is high’. How do you marry those two things together?
PT: I'm always looking for businesses that are high return on invested capital, i.e., businesses that can reinvest at a high rate right now, that is CBA. It's got the highest return on equity or highest return on invested capital. When you've got that, you normally get upgrades and that's how you create value. I've got an overweight on CBA, but I've got an underweight on the banks. I have some sympathy to the fact that maybe the banks are expensive, but I think CBA really has, to me, an unfair advantage. About 34-35% of Australians have their primary financial relationship with CBA. 67% of new immigrants have their bank account with CBA. Our population is growing by these new immigrants. So, CBA have the same platform as everybody else, but they've got more people on that platform. Structurally, they've got an unfair advantage. Their retail deposit base is bigger and it's lower cost. They pay less in term deposits and interest rates, yet people want to be with that bank because it's the safest - CBA is seen as the last bank standing in the global financial crisis. All deposits were heading to CBA, even out of the other big banks. CBA gets the lowest rate for their wholesale funding as well.
Looking forward, I think challenges are probably not going to come from a new bank starting up. They're probably going to come from technology companies. The technology companies are already playing in the payment system and that could expand further, and CBA has by far the best technology platform. So, I look at it and think, if the threat does come from the technology companies, CBA is in a much better position to withstand that threat from technology companies, whereas the other banks are in a less good position. I think that's a multiple year advantage for CBA as well. So, I think CBA almost has an unfair advantage in the market.
LDP: So, you're saying the structural strength that the CBA has, the growth profile, the investment in things like technology, despite where the valuations are, you've got confidence in that sort of growth and quality element of the company?
PT: Yes, it's got the growth, it's got the returns. That is reflected in the valuation, but to me, that's just a reflection of their superior position to the other banks.
LDP: Zara, from your perspective, how are you thinking about those two things? Marrying up the attractiveness of the company and the valuation? Because again, it's a challenge, right?
ZL: It is a challenge. It's not lost on anyone who looks at the markets closely that CBA, from a multiple perspective, is an expensive multiple and the divergence between it and its peers is big. What was interesting to me this reporting season about CBA was that they talked about a partnership with OpenAI and that they're actually allocating some investment dollars to trying to understand how they can introduce AI into the business. I suspect there's probably at least a hundred use cases for AI to be used across the bank to improve the cost base, improve the monitoring, lots of different elements whether it be HR, compliance, legal etc. where they can improve their costs.
Bear in mind that CBA nor the other banks provide any earnings guidance at all so the investors rely on the consensus estimates and consensus estimates are literally made up of the estimates of everybody. No one really has any idea what sort of benefits, things like AI and technology spend will confer on the business. But they're investing in that technology, which is quite interesting. They're in that position because they've been investing consistently for a very long time relative to peers that may have underinvested because they've had other fires to fight in terms of capital problems and challenges and so on, or acquisitions to digest. So it does create quite a market difference between CBA and the others.
LDP: What are the things you want to see from CBA in the next 12 months to reinforce that confidence in the company?
PT: To me, it's about maintaining their position. They're the clear market leader, they're the clear quality bank. I want to make sure that they maintain that lead over the other banks, so continue to invest in technology, continue to invest in their position and not really give the other banks a chance of catching up.
ZL: I would concur. Certainly, having market share holding or gaining market share in terms of the value of the customer rather than necessarily share for share's sake, and potentially some sort of productivity, from the investment dollars that they're spending, whether it be AI or other areas. So just seeing that leverage coming through. Also, managing the credit cycle, which we've had a fairly benign credit cycle because unemployment rates been low and house prices have remained very high. It's been the most unusual credit cycle of credit cycles.
