Buying and Holding a Bad Strategy if Bank Earnings Remain Unpredictable

About those cash flows...

Commonwealth Bank reported its full-year results to the ASX earlier this morning. The highlight (or lowlight) was that second-half profit fell by 16% to $4.72 billion compared to the previous six-month period. This happened despite a 19% surge in home lending to $257 billion and a smaller 6% growth in business loans to $135 billion.

Does it look like the bank is doubling down its bet on Aussie houses?

For the full year, if you exclude the $612 million after-tax profit on the acquisition of BankWest, CBA's net profit after tax was down 9%. Cash earnings fell by 7%. CBA also took a $2.94 billion impairment charge for bad loans. It took a loss on notes in failed day-care provider ABC Learning Centres and noted, "Home loan arrears over 90 days and personal lending arrears have increased on the prior year with deterioration in the second half."

Trade the banks if you'd like. In fact, that's what Gabriel says you ought to do - trade the trends. But buying and holding may be a bad strategy if bank earnings and cash flows remain so unpredictable. And we reckon they WILL remain unpredictable.

If we're right, households have just begun reducing their debt loads. It will take years for the leverage in the system to be wound down. If you're buying bank stocks you're assuming credit and debt growth will resume once this recession is over. That's a big assumption. And probably stupid.

By the way, CBA also said - presumably because cash earnings are down - that it's cutting its second half dividend by 25% to $1.15 per share. That puts the full-year dividend at $2.28 per share.

It's not shabby. But remember, you still have your capital at risk. And as Kris Sayce has shown in his debut issue of the Australian Wealth Gameplan, there are other businesses in Australia with strong and regular cash flows that also pay you regular dividend income - arguably with a lot less risk to your capital.

In case you think we're just bashing Aussie banks, we'd suggest that the profit outlook for U.S. banks sucks too. U.S. stocks fell overnight. One big reason why is that JP Morgan came out with a shiny new report that said losses at bond insurer MBIA may wipe out capital at the firm. MBIA's shares fell by 13%.

Wait! Haven't we seen this film before? Is it possible that the recovery in earnings everyone used to justify the recent rally was really just a bunch of second quarter cost cutting, and NOT a fundamental improvement in business conditions? Is it possible, as John Hussman suggests below, that the fundamentals that supported the previous bubble have vanished, making it more likely that corporate cash flows are headed lower for years to come?

Hold that thought. One of the factors that led to an increase in second quarter earnings was cost cutting. And officially, cost cutting - when it entails firing people - improves productivity. It does not, however, increase wealth.

There are two kinds of productivity. The first kind is where you produce more because you have new skills and you can do your job faster and better than before and produce something better. Your personal output rises and the aggregate output of the economy rises. That's the good kind of productivity. Everyone wins.

The other kind of productivity is where you end up doing the job of three people because two others have been fired. That is the bad kind of productivity. Your output rises. But your increased work load doesn't mean the economy is using resources more efficiently or producing more goods and services per person. You are also probably at least three times more miserable, stressed, and unhappy...having more than three martini lunches or whiskey breakfasts.

So what do you make of the fact that U.S. productivity grew by 6.4% in the second quarter according to the Bureau of Labour Statistics? It was definitely the second kind of productivity growth. Second quarter output actually fell by 1.7% according to the BLS. But total hours worked fell by 7.6%, raising the output per worker by the most since 2003.

Alan Greenspan started yammering about productivity growth in 2003, when it looked like the U.S had leveraged the tech boom into a huge structural increase in productivity. The argument at the time was that computers and modern telecommunications had led to a huge surge in productivity.

The jury is still out on that. There are some industries that would simply not exist (or exist at the same level) without computers and the Internet (ours being one of them). But whether or not modern technology has made people more or less productive is an open question. Does Facebook make people more productive? Does Twitter?

It also depends on what kind of output you're talking about. If by productive you mean, "make more stuff" or you mean "generate more work." Information technology has generated huge volumes of work - information, trading, transactions - in the financial sector. But is the economy any wealthier for it? Has the capital stock of the nation increased?

Say's Law says that supply creates its own demand. What Jean Baptiste meant by that is that you create your own purchasing power and future demand by producing goods that you can sell. Those goods generate your income and that income becomes the source of your consumption. But in that old-fashioned way of thinking about things, all economic prosperity comes from producing things of value and selling them.

We live in the dying days of an era where people think wealth comes from consumption. Why else would the government encourage consumption without production via cash hand outs? It reckons this money will stimulate production by stimulating demand. But demand comes from people having money to spend to begin with. And they can only do this if the economy and the job market are geared toward producing wealth, not spending it.

Speaking of producing wealth, Chinese firms have been busy this week chasing Aussie real assets. State-controlled Yanzhou Coal has made a $3.5 billion bid for Felix Resources (ASX:FLX). This would be China's biggest Aussie acquisition to date. It values Felix at $18 per share, which is about 10% above the closing price before Felix went into a trading halt on the announcement.

And in today's Age, Barry Fitzgerald reports that Hebei Mining - the State-owned mining company of China's Hebei province - has taken a 14.9% stake in unlisted Western Australia uranium explorer Raisama. Raisama issued Hebei 4.5 million new shares and sold it 2.5 million existing shares at 25 cents a piece.

Raisama also said that, "''The Hebei provincial Government currently has plans to build at least three nuclear reactors and is selectively securing strategic interests in uranium exploration companies internationally that it believes have the best potential to meet the province's growing need for uranium."

Despite (or because of) all the controversy over the arrest of and bribery charges leveled at Rio Tinto iron ore executives in China, Chinese firms are still busy buying Aussie resource real estate. This is happening for a couple of reasons. China has heaps of U.S. dollars it gained in trade that it would like to get rid of before America inflates the value of them away. China also has long-term resource needs.

But since we've covered both those subjects before, let's address a different part of this equation: the valuation. Is China paying too much, too little, or just enough for its stake in Aussie resource firms?

Not all assets are created equal, we mentioned yesterday. For example, Commonwealth Bank's chief assets are its loans to customers and its deposits. But the deposits are callable by customers and the loans are only worth what they're worth if people can pay them back.

With resource companies, the main asset on the balance sheet is a mine, an ore body, or a lease or a permit to drill and/or explore a prospect. Sure, mining companies are capital intensive and this capital equipment shows up (in depreciating fashion) on the balance sheet, along with cash.

But the chief asset of any resource company is the resource it hopes to produce. Just what that asset is worth depends on a number of factors. One big factor is the quality and quantity of the resource. You want to know whether it's a reserve - a clearly defined asset with reasonable projections about how much can be produced economically, given today's commodity prices - or a resource (a less defined estimate of how much of a given commodity might be underground).

Other factors are the capital spending required to produce the asset (including mine constructing and ore processing, in some cases) and the operating expenditure. For example open pit mines are cheaper to build and operate than underground mines, and projects far away from infrastructure (rail, port, roads) have much higher operating costs. Labour and raw materials are also variable costs that tend to rise in a commodity boom, as we all found out in 2007.

The great variable in all this is the price of the underlying commodity itself. That changes based on both supply (other producers) and demand (economic growth, or the variables that drive individual commodity prices, including investment demand and speculation). In the traditional commodity cycle, high prices attract more producers and low prices drive out all but the lowest-cost producers with the lowest cost ore bodies.

Judging by this week's activity, Chinese firms are happy to take a stake in existing producers with clearly defined reserves and resources. But they're also happy to pony up the capital and fund explorers who have big hopes but no production and no clearly defined asset. So what does that tell you?

Maybe China is speculating on real assets the way Australians speculate on house prices and Americans speculate on stock prices. And what does THAT tell you?

For now, it tells us that Aussie assets - both equities and real assets in the ground - are in demand. Frankly it's all sounding bullish isn't it? Will Chinese demand for Australian resources diminish if the People's Bank of China tightens monetary policy to prevent bubbles in property and the share market? More on that subject tomorrow, including the dreaded Fibonacci retracement on the S&P 500.

Dan Denning
for The Daily Reckoning Australia

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