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When a valuation bubble is not about growth...

Reece Birtles explains why the euphoria around Commonwealth Bank could unwind, potentially impacting index-aware portfolios, and why value stocks may hold the key for income and accumulation investors.

Date published
17 Jan 2025
Tag
Reece Birtles, CFA Chief Investment Officer, Australia

Commonwealth Bank (CBA) has been a popular inclusion in many Australian investors’ portfolios. We are concerned that its soaring share price is a sign of a market bubble that is about to burst and could have impact to both income and accumulation portfolios.

The CBA share price at $152 and Price to Earnings ratio (P/E) of 25x (at the time of writing) are defying the fundamental laws of gravity that typically bind Australian banks to a P/E discount to the broader market. This is because banks typically have more limited earnings growth capabilities due to their regulated capital base, and lower Return on Equity & earnings tail risk from credit losses. While CBA did have some good earnings growth in the 2000s, the more recent decade has seen it grow well below inflation and the market, with EPS up just 4% in total over the last 10 years.

It is often said that a company can grow into its P/E, but to us, what makes CBA’s valuation look extreme compared to other high P/E names is that CBA is only likely to grow Earnings Per Share (EPS) around 2% p.a. vs. stocks with a similar P/E such as CSL or Goodman Group. We believe that these stocks are likely to be able to grow EPS at a double-digit rate at least for a few years. CBA’s structural slowdown in EPS growth is driven by several factors: the high indebtedness of the Australian consumer today, stakeholder focus on fees, competition from new technology, stricter capital and liquidity requirements from APRA, and mortgage discounting that has built an impairment into net interest margins over the residual mortgage loan life. With expected growth of 2% p.a., it could take more than 20 years of zero share price appreciation to get back to a more typical P/E ratio.

With the share price where it is, the yield for CBA has also now dipped below the bond yield. And with the buy and hold return (IRR) estimate sitting near 5% (based on the 3% dividend yield and 2% expected growth), why should an income investor take on additional equity risk over cash or bonds? Even CBA themselves seem to think this, having paused buybacks as their preferred way to return capital to shareholders as a buyback is dilutive to the dividend per share (DPS).

We must keep reminding investors that we are talking about a bank, a sector which is often perceived as slow and boring. This CBA bubble is not about a strong expected earnings growth story like Xero, CSL or Nvidia. One important thing that does appear to be driving the euphoria for this stock is the weight of inflows into index funds. The investment market is experiencing several trends: outflows from active funds, strong inflows to index funds, super fund inflows in a rising market, and a focus on short term risk management due to the Your Future Your Super performance test. Additionally, there is a preference for stocks not exposed to China. These factors are creating “more buyers than sellers” in CBA, driven by its >10% S&P/ASX 200 index weight, general underweight positions among active managers, and a strong retail shareholder base.

Whilst these trends can ‘ex-post’ explain CBA’s outperformance, they don’t explain what a fair value price is for CBA and whether it is a bubble subject to the whims of one of these buying forces.

But the real question is what's going to happen next - can the CBA share price really keep rising in such an extraordinary manner despite the lack of earnings growth? Is it prudent to be investing in a stock with, on our bottom-up fundamental estimates, a greater than 40% valuation downside to its current share price? (See Key Chart 1)

History has repeatedly shown that periods of euphoria unwind and often give way to an unexpected regime change when the imbalance in the system eventually makes it fall over. Our valuation spreads for CBA, and the Australia market as a whole (See Key Chart 2) suggest that we are close to this inflection point.

Importantly, Value-style stocks have typically produced significant alpha in the 12-24 month periods following such inflection points. We believe investors really need to be thinking much more about the fundamentals and their position, or lack of position, in value-style stocks.

Key Chart 1

The following chart highlights three ways to consider how the stock price of CBA (grey bars) has surpassed the fair value of the stock by around 40%:

  • The slate-coloured line is a simple multiple calculation using broker forecasts of CBA’s next twelve month (NTM) EPS at each point in time multiplied by 15x, the long-run P/E ratio.
  • The red line uses another ‘rule of thumb’ valuation measure and shows the expected share price if the company were valued based on its DPS and a simple 5% unfranked yield, a typical level for the company pre-2020.
  • The green line is what our MCA research analyst has valued CBA at with their full bottom-up fundamental analysis of fair value at each point in time.

Price vs. Fundamentals: CBA

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Key Chart 2

Our team’s record of more than 20 years of in-house fundamental valuations of Australian companies provides great insight in understanding the scale of the opportunity for Value stocks within the market.

Our valuation assessment of CBA (see left chart), and also the S&P/ASX 200 as a whole, suggest that both are at/near their most overvalued point since our records began, and that we expect future returns to be negative over the medium term. Accordingly, we hold an underweight position in the stock in our MCA Value Equity strategy, and have significantly different holdings to the index in our portfolios.

We can also use our valuations to measure the overall opportunity for alpha for our MCA Value Equity strategy. The spread between our valuations for our holdings and stocks in the S&P/ASX 200 (see right chart) has only exceeded +40%, a critical threshold that signifies an extreme value opportunity, in periods such as the GFC and Covid (shaded in grey). From this wide level, the MCA Value Equity strategy has historically produced significant alpha over the S&P/ASX 200 Accumulation Index over a full style cycle.