Record Profit (Again) for Commonwealth Bank…but Should You Buy?

One of the most amusing phrases in investing is this one:  ‘Markets hate uncertainty.’

Oh really?

Investing is inherently uncertain. You don’t know what’s going to happen tomorrow, next week, or next year.

Investing is all about uncertainty.

The question is how much you’re willing to pay for it.

Perception of Certainty

A more accurate phrase would be: Markets love the perception of certainty. The greater this perception is, the less fear there is, and the higher stock prices are.

Take a look at the VIX index, for example, also known as the fear index. It’s at its lowest point in decades (although I’ve only shown it over the past few years, below).

Source: Optuma
[Click to enlarge]

This is a market with no worries, no uncertainty. Why protect your downside (by buying put options, for example) when there is little downside risk?

So the thinking goes, anyway.

But history shows that when complacency is at record lows, it’s a good time to think about how an increase in the perception of uncertainty could impact stock prices.

You can’t see it on the chart above, but the VIX surged 10% overnight.

The reason?

Trump warned that North Korea would be ‘met with fire and fury like the world has never seen,’ as he learned about its emerging nuclear capability.

North Korea has always been a loose cannon. But it’s fast emerging as the world’s trouble spot. The perception of uncertainty over it is now rising.

Will this flare up subside, like all the others involving North Korea? Probably. The rule of uncertainty is that it surfaces where no one expects it.

Like the accusations of a failure to report money laundering recently made against the Commonwealth Bank [ASX:CBA]. While I doubt there’s a major bank in the world that isn’t unwittingly a conduit for dodgy money, that fact that the CBA will have to defend itself in court is a major uncertainty for investors.

You can see this in the bank’s share price reaction since the news hit last week. Before the allegations, the stock price was around $85. Yesterday’s closing price was $80.65. That represents an $8bn loss of market value.

Source: BigCharts
[Click to enlarge]

Where to From Here

Technically, the recent move is damaging. It suggests CBA’s share price is going nowhere for some time. The uncertainty over the ‘where to from here’ supports this view.

If I had to guess, I’d say the outcome will be a decent fine, assurances that it won’t happen again, and then business as usual. That’s the higher probability outcome.

The low probability outcome would be a massive, profit-denting fine that knocks the stuffing out of the share price.

Right now the market is betting on the higher probability outcome. That makes sense. But if the share price continues to fall and breaks below the recent low around $78, then you’ll know CBA is in a bit of trouble.

What makes the allegations particularly acute for banks right now is their need to bolster equity capital ratios, as mandated by bank regulator APRA, to 10.5% by January 2020.

The CBA’s equity capital ratio currently stands at 10.1%. Any draining of equity capital from fines would be a setback to achieving this goal. That’s something to keep in mind as this saga continues to unfold.

From a charting perspective, there is no reason to buy CBA right now. It’s a hold at best.

But fundamentally, the bank continues to perform well. The CBA just reported another round of record profits. Cash earnings for the year to 30 June came in at $9.88 billion, up 4.6% on last year.

It was slightly ahead of expectations, so the market should like it.

However, the all-important profitability gauge, return on equity (ROE), declined 50 basis points over the 12 months, to a still healthy 16%.

Change in ROE is a key driver of share price performance. It reflects how profitable each dollar of equity capital is. When ROE rises, investors are willing to pay more for a business. When it declines, they will pay less.

That the CBA generates an ROE of 16% tells you both how dominant the bank is and how favourable the cycle is right now.

And it’s all about low interest rates. Low rates help banks in every way. Notably, CBA’s impairment expense, also known as bad debts, fell 12.8% over the year to $1.095bn.

As a percentage of loans, bad debt expense is at the lowest in more than a decade. The expense represented just 15 basis points of gross loans, compared to 73 basis points in 2009, at the height of the credit crisis.

Had the bad debt expense remained the same as last year, it would have wiped $160 million off the bottom line. Instead of beating expectations, the bank would have ‘disappointed’ the market.

While not a disaster, it just goes to show how low interest rates boost bank profits in every way. You would have to imagine that any rate rise by the RBA from here will have a sharply negative impact on the banks.

I mean, how much lower can bad debt charges go?

Not much.

It’s another reason to avoid the banks. The dividends might look good, but you can give that up in a few bad days of trading.

There are better opportunities out there. More on that when I return next week.


Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

Money Morning Australia