Every Tuesday afternoon we publish a collection of topics and give our expert opinion about the Equity Markets.
Last week, the Commonwealth Bank of Australia (ASX: CBA) achieved a historic milestone, becoming the first Australian-listed company to surpass a market capitalisation of A$300 billion. This remarkable ascent has sparked discussions among investors and analysts regarding the sustainability of such valuations and the underlying factors contributing to this surge. ABSI this week looks at CBA’s crazy valuation and the role of passive investing in this price-taking environment.
I want to start by saying that CBA is a great business that is extremely well-run. It stands head and shoulders above its competitors, including a market-leading share of home lending (~25%), household deposits (~30%), and superior ROE of 13-14%. Additionally, unlike legacy banks in other international markets, CBA has held off challenges from start-up neobanks by becoming the most digitally advanced bank in the country. CBA is a great business, but is it really worth 30x earnings in comparison to competitors trading at 13- 17x in a mature low-growth sector?
Source: Google Finance
The answer is invariably no, but this could have been said for the last 12 months and yet the stock is up 43% over that period. A big part of the reason is that the current valuation is underpinned by a self-reinforcing flywheel whereby:
- CBA is the largest stock on the ASX.
- Passive investment inflows, particularly from superannuation funds, invest disproportionately into CBA at any price.
- CBA’s share price appreciates, increasing its index weighting and furthering the cycle.
The bull run in CBA is shining a spotlight on the growing concentration risk exhibited in the ASX200 index in Australia, which is starting to reflect a similar phenomenon in other stock market indices, particularly the Nasdaq 100, thanks to the growth of the Magnificent-7. At a A$300b market cap, CBA now constitutes ~11.5% of the ASX200 index, meaning that for every A$1,000 invested into an ASX200 index fund, ~A$115 is allocated to CBA.
Continually, the top 10 stocks in the ASX200 now account for almost 50% of the entire index, making it one of the most concentrated indices globally. This issue is compounded by the lack of diversification in the top 10 stocks with 5 representing the financial sector and none exposed to high-growth technology businesses (the lack of tech representation is a completely different story) and other important sectors.
Source: BPC, Market Data
Warren Buffett famously espoused the benefits of passive investing back in 1993, and he wasn’t wrong, but the pendulum has swung too far towards passive. The market is now being heavily driven by flows, not fundamentals, whereby most participants are price takers, not price setters. The Australian superannuation system is the biggest culprit in this regard. Every year, over A$117 billion in funds flow into superannuation, and understandably, these stewards of retirement savings have been moving away from high-cost active managers to low-cost passive management. The unintended consequence here is that the ASX large-cap market has become completely distorted with price formation without valuation.
It is important to note that it isn’t just pension funds to blame. CBA is a legacy stock that was privatised by the government in 1993 for $5.40/share. Over 30 years later, long-term holders of the stock are sitting on returns of over 3000%. Retirees are better off holding and enjoying the fully-franked dividends rather than selling and crystallising a capital gains tax gain in order to diversify their asset base. Additionally, for those lucky enough to inherit shares, the generosity of the Australian tax system means that these people can inherit the cost base, further disincentivising the sale of shares.
CBA is a screaming sell at these price levels, and every institutional analyst on the street agrees, but nobody is advising to short the stock because it is unclear when the flywheel will unravel. Some potential catalysts for a downgrade include lower interest rates compressing margins and stimulating flows out of deposits and into riskier assets, or an economic downturn resulting in loan defaults, however timing of these events is difficult to predict. As a result, most investors are taking an index-neutral approach to holding CBA, which won’t solve anything.
CBA is the case study of a problem with modern markets. What began as a great business, justifiably trading at a premium to competitors, has morphed into irrationality driven by a collision of macro and microeconomics. Eventually, the momentum will change, and active management will be ready to pounce, but until then, check your index positions and ensure you’re exposed to a broad-based ETF with global diversification to avoid the pitfalls of extreme concentration in overvalued stocks.
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