Rethinking bank shares

I feel like a broken record…

I feel like a broken record…

Since my ol’ days as a freelance writer at The Motley Fool Australia I’ve been saying as I typed:

“I reckon it’s not a good idea to buy bank shares because there are clearly better options.”

Fast forward five years to now…

Here are the per share annual total returns (dividends + share price movement) from Big Bank shares over the past five years (according to Morningstar):

• CBA: negative 2.8%
• NAB: negative 5.9%
• ANZ: negative 7.5%
• Westpac: negative 8.7%

To be clear, I don’t feel good about shares falling.

But, please, take note of what I’m about to say…

There are 2,000+ shares on the ASX.

There are 10,000 shares overseas.

There are ~220 ASX-listed exchange-traded funds (ETFs).

There are ~2,100 ETFs on US markets.

Does Rask own bank shares?

To think shares in a big bank would have made their way into the Rask portfolio – my portfolio, which I now mirror with Rask Invest – five years ago…

That would have been a bad joke around my house.

Why?

Here’s what I believed back then (and still believe now, to some extent):

1. Bank shares weren’t cheap. As measured by their price-to-tangible book values, dividend discount models, etc..
2. Net interest margins were being squeezed by low-interest rates (note: the “NIM” tells you how much a bank makes when it lends money to borrowers). Extra point: the only way to make more profit when your margins are being squeezed is to add leverage or pump more revenue through your business.
3. In my opinion, the banks had been serving Aussies crap financial advice with misaligned cultures and incentives for far too long. Meaning, their ‘wealth’ and insurance arms, which were quite profitable, were always on the chopping block to be sold. Royal Commission or not.
4. Bad debts were at record lows… but banks are cyclical. Hello, 2020…
5. The banking sector was becoming more – not less – regulated.

…anyway, we all know what’s already happened.

And I always try to keep my newsletters positive because that’s the way we invest: we do our best to buy companies that change the world, for the better, and of course we aim to make a lot of money as we go.

Indeed, what happens next with banks is still up for debate. And I’m reasonably confident there will come a time to buy bank shares if an investor is so inclined.

But rather than prognosticate over the specifics, I’ll go back to my first point and repeat what I’ve said for years: look outside the banks for dividend income.

There are so many options!

Sure, the “historical dividend yield” on some stocks or ETFs I buy might not be as tempting as the banks. But what matters is total returns.

That is, dividends plus capital gains. Or in the banks’ case: dividends minus capital gains minus the negative effect of capital raisings.

There’s a reason we call some dividend stocks “yield traps”.

How we’re managing the ‘dividend crisis’

At Rask Invest, we don’t specifically target dividends because we believe, as most investors with a five-to-10-year investment horizon should, that we would be doing our members a disservice by limiting our choices to stocks or ETFs with high yields only.

In my opinion, any investment in the share market should be considered a minimum three-year commitment, especially in this environment.

If we take a three-year view, does last year’s dividend really matter?

No.

Indeed, as much as I love franking credits, what matters to investors is finding stocks/companies that are capable of compounding (i.e. reinvesting profits in their own businesses) at rates we can only dream of as private investors.

Some companies on the ASX achieve returns on investment capital (ROIC) of 100% by investing back into their businesses. Don’t believe me?

Here are the returns on capital (ROIC) of the Australian jewellery business, Lovisa Holdings Ltd (ASX: LOV):

• 2015: 220%
• 2016: 72%
• 2017: 131%
• 2018: 98%
• 2019: 64%

Eventually, these “cash boxes” compound so fast and so hard that their share prices can’t help but go up.

And once the market catches on… make sure you strap in for the ride.

Even with a big share price fall recently, ​Lovisa shares have risen from $3.14 in May 2015 to $6.93 today, according to Google Finance.

Core + tactical

Our simple, general investment advice to members and readers is this:

Build a core of diversified and low-cost ETFs and managed funds.

Then, if you want to, add some blue-chip shares for extra income. You can read my write-up of Washington H. Soul Pattinson (ASX: SOL) – I’d consider buying SOL before NAB or Westpac shares.

Finally – and this is the exciting part – only ever buy shares of companies capable of compounding (ROIC) viciously over a very long period – meaning they must have strong businesses, long growth runway and competitive advantage.

Earlier this month, I wrote to all Rask Australia readers about the little-known ASX-listed software company RPMGlobal Holdings Ltd (ASX: RUL).

It’s been held by Rask Invest for quite a while. It’s one of the small-cap share picks on our public scorecard (available on rask.com.au).

You can read my full report on RPM and listen to the podcast by clicking here.

The information in this article is limited to general financial advice only. That means the advice does not take into account your objectives, financial situation or needs. Because of that, you should consider if the advice is appropriate to you and your needs, before acting on the information. If you don’t know what your needs are, you should consult a trusted and licensed financial adviser who can provide you with personal financial product advice.

Disclosure: at the time of publishing, Owen Raszkiewicz owns shares of RPMGlobal 

Drew Meredith

Drew is publisher of the Inside Network's mastheads and a principal adviser at Wattle Partners.