Australia and New Zealand Banking Group (ASX: ANZ) has got off to a strong start in 2015 with its shares rising 10.4% and outperforming the S&P/ASX 200's (Index: ^AXJO) (ASX: XJO) return of 9.9%.
However in the past month shares of our third largest bank by market capitalisation have shed close to 4% of their value.
No doubt, with volatility persisting, savvy investors would be asking themselves if this is a good buying opportunity.
What it takes to buy a bank
Before buying into a bank stock, it's important to have an understanding of how they work.
As many people know most banks make money from lending cash on deposit to mortgagees, businesses, car owners and credit card holders. This is called interest income.
The difference between interest rates banks lend money at versus what they must pay on their deposits is known as a net interest margin. It's a key measure of bank profitability.
Here's how ANZ's interest income and net interest margin have fared in recent years.
As can be seen from the graph, ANZ's net interest income has risen strongly, which is likely a result of the bank's 124% rise in net loans and advances between 2005 and 2014. Such a rise could perhaps be attributable to the boom in Australia's housing and resources sectors.
As is also evident, ANZ's Net Interest Margin, or NIM, has been volatile but is on a downward trend. This is a common theme amongst Australia's big banks, with pundits accrediting the margin erosion to intense competition between the big four institutions, the rise of regional banks and non-bank parties, such as mortgage brokers.
The regulatory environment has also played its part in the bank's declining profit margins.
The other key generator of bank revenue is known as non-interest income. This measures things outside of lending but those which would usually complement standard bank operations. Think things like superannuation, funds management, financial planning and more.
This is a key aspect of ANZ's – and its peers – growth strategies moving forward. ANZ, whilst targeting 30% of all group revenues from Asia by 2017, recognises the tailwinds behind the funds management and superannuation industry in the domestic market.
In this respect ANZ's non-interest income has grown from $2.93 billion in 2005 to approximately $5.9 billion today. It contributes roughly 30% of total group income.
Valuation
As you can imagine banks make more money when demand for loans is high and costs on deposits are low. Right now, we're seeing this play out in Australia. Property investors, businesses and everyone in between are taking out loans to make investments whilst interest rates remain at record lows.
Meanwhile debt markets in Europe and the USA are exceptionally cheap – some European bonds even have negative yields! This is a boon for ANZ and its peers.
However it can be cause for caution for long-term investors.
Bank profits, like markets and interest rates, are cyclical. So investors should aim to buy bank shares in a market trough. This is when charges for bad debts (loans which haven't been serviced for more than 90 days) are cut directly from the banks' profits.
Currently ANZ might look like a bargain with its shares trading at a price-earnings, or PE, ratio of 13.3 times. However this is very misleading because it does not factor in the cyclical nature of bank profits and their leverage to market conditions. ANZ's three-year adjusted PE ratio is 15.
However investors should use the price-book, or PB ratio, instead of a PE ratio.
The PB ratio measures the price relative to the accountants' value of its assets, minus liabilities. A common rule of thumb is to purchase bank stocks at, or below, parity with book value (i.e. less than 1.0 times). With ANZ shares currently trading at a PB ratio over 2x times (or nearly 2.5 times tangible book value!) it does not appear good value today.
Buy, hold or sell
ANZ profits – like its peers – could be near the peak of their cycle. Therefore investors planning to invest (rather than speculate on short-term price movements) must factor this into their investment thesis. Unfortunately, likely a result of investors' search for yield, the market does not appear to be pricing ANZ for what likely lays ahead.
In summary although ANZ may be one of the more profitable and fast-growing big banks, I believe long-term investors are afforded no margin of safety and would therefore be advised to avoid the stock, for now.
