Can Kiwi investors piggyback on bank sector profits or are the days of high yields numbered? And why does Janine Starks think you should get your head checked for asking?

By Amanda Morrall

Since ASB's 2001-2002 financial year, the bank has paid total dividends of NZ$3.18 billion, or an average of NZ$318 million a year.  

The pay outs would appear to be a good endorsement for buying shares in the parents of the big New Zealand banks.

At the same time, trends world-wide are not encouraging. The 24-member KBW Bank Index, which fell 85% during the global financial crisis, is showing signs of distress. So far this year, it's down about 31%. 

Yet New Zealand banks are showing relative vigour.

Their profits have been reported to be the second highest of 22 member nations of the Organisation for Economic Cooperation and Development, with post tax return on equity averaging 18% from 2002 to 2007. (For more see Gareth Vaughan's piece on growing bank profitability here.)

Despite these respectable returns, Christian Hawkesby, head of fixed income for Harbour Asset Management Ltd, believes there is reason for caution.

He makes the  following points:

1) The NZ banking sector is Australian owned, so you need to buy the Australian bank stocks to get the exposure.

2) Australia has a very two-speed economy with a very strong resources/export sector offset by the Reserve Bank of Australia keeping monetary policy restrictive to cool the consumer sector.

3) A weak consumer sector and risk of a sharp housing slowdown is negative for banks, both through weak loan growth and the risk of higher impairments.

And finally: "Through global wholesale funding markets, the Australian banking sector is one of the most exposed sectors to developments in Europe and the US.  There are concerns about the ability of some European banks to access funding markets, and there is a risk this spills over into a more general freeze in funding markets.  Over the last couple of weeks, credit spreads on Australian banks have been marked wider, reflecting those risks."

See our interactive chart below and here to see how much those spreads have risen.  And for a good explanation of credit default swaps, watch the BBC video clip below.

'Good psychiatrist required'

Fund manager Janine Starks is even more wary of bank stocks and more forthright in her assessment of why they ought to be avoided right now.

"Individual investors buying banking stocks right now, should probably invest in a good psychiatrist,'' said Starks, managing director of Liontamer.

While New Zealand and Australian banks might, on the surface, have the appearance of being more stable than their countertops in Europe, Starks said the contagion risk was such that few professional analysts knew how to call the situation, let alone private investors.

"We have a situation where the French and Germans are trying to keep things very calm and they may succeed, but on the downside, the Euro could explode in spectacular style and cause massive market ruptures and possibly cause banking failures. It’s an extreme scenario, but can’t be discounted.''

Some Canadian bankers are seizing the moment, selectively add cheap U.S. bank stocks to their own portfolios. Read more here.

Starks maintained that  the only sensible way to invest in this sort of theme was through a fund manager "experienced at picking value" also one who could spread their bets widely, or via a capital protected funds, incidentally the boutique fund manager's speciality.

While Liontamer has in the past offered a fund that invested in undervalued bank stocks expected to rise, Starks said there was no such offering for investors right now. Current levels of volatility prevented it.

Capital protection?

Starks argues the capital protected funds served to buffer against major losses, such as what occurred during the global financial crisis. She used Liontamer's Fallen Angels fund (a basket of 16 stocks, 8 of which were banks) as an example.

The fund launched in July 2008, just before markets collapsed, has two protection mechanisms; one, - investors at the end of a five and a half year term get their original investment back, regardless of share prices declining. Secondly, it has a 'smart-start,' feature which essentially allows the fund managers to reset the opening level of the shares over the first six months of the fund.

While share prices for that particular fund subsequently fell by 50%, the reset option effectively means that the fund has risen by 40%.

Starks said investors buying bank shares directly don't have this kind of maneuverability. She said investors contemplating buying bank stocks, needed to weigh the potential gain against the possibility of losses.

"My warning to anyone currently looking at buying banking stocks, is that ‘all that glistens is not gold’. Always consider whether you can afford to suffer massive losses, in return for the potential gains.''

Regulatory change?

And reform in the banking sector, post GFC?

Reserve Bank governor Alan Bollard said while "operating conditions for the banks have changed profoundly since the financial crisis, it was still too early to be definitive about how it will affect the financial performance of banks going forward."

The implications for those looking to invest in bank stocks? Proceed with caution.

Many banks are in the process of deep restructuring, the effects of which are being felt by staff who are being shed by the thousands.  The Financial Times reports on the regulatory effects on banking staff in this piece here.

And for existing shareholders? Bollard suggests they might have to lower their expectations.

"Regulatory changes designed to create safer banks might be expected to lower required rates of return over time.''

That's because despite current profitability in the New Zealand banking sector, Kiwis are still clearing in debt and restraining themselves from mindless consumerism. Bollard said if the trend endured banks would have less opportunity to generate higher profits through balance sheet expansion. 

On top of that New Zealand banks would be paying more to borrow money from offshore markets due to a combination of higher risk aversion, global regulatory changes and sovereign debt issues. Big Kiwi businesses were therefore turning away from the banks, raising money themselves.

Bollard said the banks’ ability to recover higher funding costs from customers would depend partly on the strength of loan demand as well as competitive pressures from other parts of the financial sector.

"All things considered, it seems unlikely that the rates of return in banking enjoyed over the past decade can be sustained in the future,'' he concluded.

Investors looking to cherry pick bank stocks, may do well to invest in a crystal ball as well.