- "I just like 'the look' of the company..."
- "The price has fallen 25% and I reckon it will bounce."
- "My mate down the pub tipped XYZ as the next 10 bagger..."
Graham suggests 7 criteria for defensive stock selection. Let's take a look and then apply to Australia's stock market of today.
Smaller companies can show great growth potential, but that is not the point of the discussion here, where we are seeking solid, defensive investments. Today, an enterprise of an "adequate size" might refer to a company with a market capitalisation of at least a couple of billion dollars.
For this reason, Graham suggests that long-term debt should not exceed the net current assets (and for a public utility debt should not exceed twice the stock equity at book value).
CBA's 2012 Annual Report (page 7) shows the Groups Return on Assets and cash net profit after tax (NPAT) moving upwards very strongly. And CBA's full year dividend has increased from 224 cents per share at June 2008 to 334 cents per share for June 2012. Magic.
Earnings stability for the banking sector has been reasonable and the sector presently has low 'Beta' values. So far, so good.
Whoa! Take a look at the liabilities: deposits and other public borrowings of $437,655 million as compared to net assets of only $41,572 million? High leverage.
The top half of the balance sheet (the bank's assets) show loans due of more than $525,682 million which the notes to the accounts show overwhelmingly relate to home loans in Australia ($320,570 million) and overseas home loans ($30,063 million) such as in NZ.
So the banks are unusual beasts with massive exposure to residential property. Naturally mortgages are issued are usually secured against property worth more than the loan but with a net asset position of only $40 billion against home loans of $350 billion, CBA has exposure to loans going bad. Of most concern would presumably be some of the 100% LVR loans which were being dished out before the financial crisis.
On the plus side, unlike physical residential property, bank stocks are liquid. You can choose to sell up at any time, which is not always so easy to do with an illiquid asset such as a house.
Of course, the banks undertake all manner of risk management solutions, capital adequacy and stress tests, but the transparency and disclosure thereof is questionable. New rules will gradually come into place, commencing with the regulatory standard BASEL III in coming years.
So, would Graham dare to venture into the banks as highly leveraged as they are? Well, he might because the banks are seen as "too big to fail" and receive an implied guarantee from the Government and have the potential to earn great profits. However, at today's prices, as I'll explore in more detail below, the banks do not meet the criteria for defensive investors.
Westpac (WBC) has a PE ratio of 13 and price-to-book of 2. And ANZ clocks in at PE of 12 and price-to-book of 1.9. Only NAB is close to meeting Graham's criteria at a price-to-book of 1.6 and a PE of 12 (NAB today has a market cap of $69 billion and its 2012 Annual Report shows net assets of a shade under $44 billion).
Is it sometimes OK to pay more?
Take a look at CBA with this in mind with its PE of 14 and a price-to-book of 2.5, giving a total of more than 30. That's way too expensive for a defensive investor in Graham's eyes.
So, there you have it. Going back to the time-honoured principles of defensive value investing, the major banks such as CBA, ANZ and WBC do not qualify as defensive investments.
I hold shares in all of them and some of the smaller banks (both directly and indirectly through LICs because I focus on the growing dividend streams) but must acknowledge that at today's share prices a correction could potentially be quite sharp. If that does eventuate and prices fall sharply I would be looking to buy more.
However, if you have an investment plan that sees you worrying about a share prices falling in the short term (CBA is trading at a premium to its book value which is 40% too high for Graham's defensive investor criteria and he'd prefer to see it trading in the $40-$50 range) then other stocks offer a more defensive investment strategy.
Disclaimer: I don't advise on individual shares to buy or sell. Each individual investor has a different financial profile, so consult a licensed professional before committing to any investment decisions.