By Tim Lincoln, Managing Director, Lincoln

The Australian banking system is currently profitable, well-regulated and stable. Due to the recent government guarantee on deposits we are currently seeing a 'flight of capital' to the major banks by customers. With banks now trading at historical lows, now may be the time to increase your holdings in the banks.

Historically banks have been considered as defensive shares. This is due to them consisting of large, well 'regulated' corporations with diversified operations providing stable dividends. However, the current 'credit crisis' and subsequent market turmoil experienced over the last year has rocked the world and can be largely attributed to the activities of the financial sector globally.

Lincoln Financial Health model - the banks

Lincoln's number one Golden Rule for successful investing is Financial Health, where it is imperative that companies demonstrate they are profitable, have strong cash flows and a sound balance sheet with management working their asset base efficiently and profitably. (Refer table below for Lincoln's current financial health rating on the major banks).

If a company has a 'Strong' financial standing it will be interpreted as having sufficient cash flow and a balance sheet robust enough to finance growth, withstand significant business shocks or prolonged economic downturns. Source: Lincoln Stock Doctor

Why banks have been a staple investment

The main attraction of bank shares in the past has been the opportunity to earn capital gains as well as solid dividend yields. We believe that fair capital gain opportunities will be possible in the years ahead due to their currently low prices. Furthermore, we believe that the high dividend payouts will be maintained, as the banks will be loath to send the message to the market that they are unsustainable. In order to ensure that their current dividends are maintained we believe that the banks will look to cut costs (eg. staff cuts at ANZ), raise additional capital (eg. the NAB) or underwrite their Dividend Reinvestment Plan (DRP).

The big four banks traditionally payout around 65-70% of their net profits as fully franked dividends. Their dividend yields range from 8.38% for the WBC to 10.51% for the NAB. The major risk for the banks to maintaining their fully franked dividends is a fall in profitability caused by a slowdown in the domestic and global economies. Furthermore, as they expand overseas the amount of overseas income as a proportion of total income will rise meaning that their ability to pay fully franked dividends may come under review.

The current status of our banks

In the current market downturn we are seeing a slowing in this sector. This is to be expected as bank profits tend to follow the economic cycle. The economic conditions in Australia have deteriorated during the December quarter 2008 with credit growth contracting for both business and consumer lending. This is the first time in 16 years that the level of growth has been negative. Looking ahead, Australia appears to be heading for a recession, the effects of which have not fully impacted the major banks at this time.

The wealth management divisions of the banks have seen a decline in their funds under management and hence their level of profits as a result of negative net flows and widespread market declines. Furthermore, the United States, United Kingdom and New Zealand economies are all in recession. Business and consumer confidence levels in these countries are at historic low levels. Although the banking environment is tough in these countries, we expect that the profits will be lower but we do not expect losses.

On the upside for the major banks we are seeing a flight to quality as the smaller players and foreign banks struggle. This was seen in the CBA's margin expansion in 1H09, as well as growth in their loan book and retail deposits growing at a rate faster than system growth. Although the major banks may be picking up market share at the moment, their share price performance has been below that of the All Ordinaries for the past year.

Outlook

The main risks with buying banks in the short term are the increasing bad debt provisions and transparency issues of their positions in the currently worsening domestic credit cycle. Higher provisions for corporate and consumer bad debts in a slowing domestic economy means that we believe the banks will deliver single digit EPS growth at best for the next few years. Given the low and negative EPS growth forecasts and the worsening credit cycle conditions, in the short term further share price falls are possible, however for a long term investor they are creating an opportunity.

Diversification is the key

In summary, bank profits tend to follow the economic cycle and in the current market downturn we are seeing a slowing in this sector. That said, with an almost 30% weighting in the All Ordinaries Index, it is important for investors to have some diversification exposure to the financial sector. Your bank investments should however, reflect a minimal to no exposure to the 'toxic' sub-prime assets.

Although market volatility is expected to continue in the short term, the large Australian banks will survive the credit crisis. These banks should provide strong, long-term returns in normal market conditions (minimum 3-5 year timeframe). Coupled with high dividend yields, exposure to strong banking stocks may be suitable for both value and income investors with a long term time horizon. Additionally, we believe that long term investors should consider a diversified position within the sharemarket. As part of this diversification we recommend that investors now consider the benefits of including banks in their portfolio.

Finding value

A number of banking opportunities are beginning to emerge with value and Westpac is well-positioned to weather the current global economic problems. It has no direct or indirect exposure to US sub-prime mortgages, as well as no exposure to specialised investment vehicles. They have a strong funding, liquidity and capital position and they have delivered 6% cash earnings growth for FY2008. The recent merger with St George is on track to deliver a stronger organisation with a better platform for growth. This includes increased customer and product diversity, improved efficiency and a stronger funding and capital position. However, given the recent volatility, the market does worry that they may have overpaid for the St George acquisition, when compared to the Commonwealth Bank's acquisition of Bankwest.