We have reduced the Commonwealth Bank (CBA) position in the portfolios and reinvested most of the proceeds in the existing Telco holdings, Telstra (TLS), and Spark NZ (SPK). These changes express our more cautious stance on economic growth and the housing cycle in Australia and other developed economies, where low interest rates, quantitative easing and fiscal stimulus have driven an unsustainable global housing market.
Australian banks prudently prepared for a spike in bad debts at the outbreak of the pandemic, which didn’t eventuate mainly because of the scale of the policy response. Dividends payout ratios have returned to historic ranges, earnings have recovered to pre-pandemic levels for CBA and buybacks that are underway now look likely to be the extent of capital management initiatives in this cycle. Normalisation of monetary policy has been late in this economic cycle and is now catching up relative to inflation and wage growth. There is heightened risk of a secular slowdown in the sectors which led the economy through the pandemic and perhaps a broader recession due to the pervasive yet lagged effect of rapid interest rate hikes. Prima facie, banks benefit from higher interest rates but they can also be too much of a good thing. CBA is trading on a record 50% premium valuation relative to the other major banks with a price earnings ratio of 16.5 times forward year earnings per share estimates and a forward year dividend yield of 4.5%, where the other banks range from 10.1x (ANZ) to 12.1x (NAB) and 6.8% (ANZ) to 5.8% (NAB) on the same basis.
We prefer the outlook for telecommunications in the event of an economic softening, where the improved industry structure in Australia has seen Telstra and Optus announce matching price rises of ~5% during July, with Telstra indexing prices to inflation amid continuing strong demand for mobile data services. This rational behaviour is encouraging for the outlook for industry returns and there are precedents in offshore markets which exhibit rational market behaviour and strong returns. Telstra trades on a one year forward EV/EBITDA multiple of 7.8 times with a forecast dividend yield of 4.1%. Spark NZ operates in competitive markets but has scale advantages and a good record in cost control. It has a strong track record of meeting or exceeding earnings expectations and trades on a forward EV/EBITDA multiple of 9.3x and a dividend yield of 5.1%.