One of the world’s most successful investors Warren Buffet once said “Charlie (Munger) and I would much rather earn a lumpy 15% over time than a smooth 12%.”

The operative words in Mr Buffett’s contention are ‘lumpy’ and ‘smooth’. This can be applied through the lens of absolute return (15% vs 12%) as well as relative return (returns relative to a market index) investing. What he means by this is that he’d rather bear the pain in active investing of having some periods of lower returns if it means delivering superior performance over the longer term. And you can see why. Consider that $100,000 invested at a lumpy 15% per year over 20 years would leave you with ~$1,640,000 compared to only ~$965,000 if invested at a smooth 12%. Who wouldn’t want a superior, but lumpy return!

The challenge of lumpiness in returns

Of course it is not that easy. Behavioural psychology of investors and their clients come into the picture too. As much as the final ‘investment return’ destination is critical, the journey is also important.

The challenge for active fund managers and their clients is how much lumpiness over say a 10 or 20 year time horizon they are prepared to accept as part of this journey? When is the ‘pain’ of the lumpiness too excessive and possibly of the poor investment decisions? How long are investors prepared to wait to be rewarded for accepting lumpiness in returns?

Over the last year, investors in the Australian share market have been grappling with this challenge particularly when it comes to portfolio positioning in the four major listed Australian banks. Together, they constitute over 20% of the ASX200 index, so consequently have a meaningful influence on the ASX200 index’s return.

Starting 2024, by a number of measures, the banks were already fully valued and faced a tepid earnings outlook. Many portfolio managers were underweight in their investment in these banks relative to their index weight. Yet by 31 December 2024, the scorecard showed that all four banks handsomely outperformed the ASX200 which delivered a 13% total return (in A$) in the year. In contrast, Westpac returned +53%, CBA returned +44% and NAB delivered +29%. ANZ, the laggard of the four, still returned a decent +18% in the year (Source: Bloomberg).

This outperformance was a headwind and added to ‘lumpiness’ in returns for active fund managers with underweight positioning in the banks. Hopefully that return headwind was compensated by smart positioning in other companies that also performed well.

Why did the banks share prices rise so much in 2024?

Part of the strong return performance for the banks stemmed from fundamental reasons. Earnings held up better than many expected. Following a sharp increase in interest rates in the preceding two years, the Australian economy proved to be more resilient than had been expected. In fact, the recent December 2024 data from Australian regulation authority APRA still showed household credit growing at 5.9% annualised, and business lending growing at a healthy 9.8% annualised rate. With unemployment remaining at low levels, bad debt charges for the banks have remained low. This has been supportive for their share prices.

Multiple expansion also played a big role in share price returns for the banks

Despite the benign economic environment, cost pressures (including never ending technology investments) weighed on profitability, meaning earnings growth proved elusive over the year. Overall, after tax cash earnings for the majors actually fell by 5% in FY24 compared to FY23.

In other words, the strong, positive share price return for the sector was driven by earnings multiple expansion. The banks are more expensively valued today than they were a year ago.

Barrenjoey estimates that on a Price-to-Earnings (“P/E”) basis, the banks (skewed by CBA) are now 4 standard deviations more expensively valued than their average P/E multiple dating back to 1996.

They are in rarified air in a valuation sense.

What have investors done in response to the banks share price performance?

The outperformance of the banks has naturally increased their weighting in the market index compared to other companies. This in turn has driven increased buying by passive funds. They are bound by definition to retaining their index weighting of the banks to deliver ‘smooth’ relative returns to their investors, irrespective of how expensive the banks get.

Morgan Stanley categorised the share registers of the banks into three classes: retail investors, domestic institutional investors and offshore institutional investors. They found that offshore and domestic institutional shareholders hold a larger share of the share registers today than they did a year ago. Partly due to the flow of passive money into the banks, and partly from active investors reducing underweight positions in banks.

With its open market economy and strong rule of law, Australian equities have generally been seen as an attractive investment destination for international investors compared to other countries in the Asia Pacific region. This likely also helped drive the share price performance of the banks.

How will the banks perform from here, and how might investors react?

Although expensive, the banks enter 2025 with share price momentum behind them. The major banks have a scale advantage over their smaller peers. They have benefited from robust bank regulation in Australia and New Zealand over the years. Compared to international peers, they are well run by credible management teams. The Australian major banks are arguably some of the highest quality banks globally.

Looking forward, analyst earnings expectations are for low single digit (in % terms) earnings growth for FY25 and FY26. Yes, given robust credit growth and the stronger than expected performance of the economy in recent months, analysts may be underestimating the earnings potential looking forward. Earnings could surprise to the upside.

With inflation subsiding, interest rates have stabilised. The Reserve Bank of Australia (“RBA”) is expected to cut interest rates in 2025, providing further relief for borrowers. This may continue to keep a lid on bad debt charges and further bolster demand for credit. The lucky country could live up to its name once more and avoid the recessionary environment in which we find ourselves in New Zealand

The backdrop for the banks is supportive.

However, after the share price returns and multiple expansion experienced in 2024, the banks are arguably priced for this. Even if the banks beat analyst FY25 earnings expectations – given the elevated valuations - will the share price momentum continue, or run out of steam? Time will tell.

This provides a conundrum for investors. Further complicating their decision making, part of the answer also lies in how other sectors of the stock market perform as well. The banks share prices don’t move in isolation to other sectors.

Ultimately, investors in Australia would do well to stick to their respective processes and philosophies in arriving at their answer on relative positioning. They should weigh up how much ‘lumpiness’ they are prepared to accept in their investment return journey. Linked to this they should also consider the timeframe over which they are prepared to accept ‘negative lumpy’ returns from what is a large constituency of the Australian market.

The craft of investing is never easy, but always interesting!

An amended version of this article appeared on the NBR website on 28 January 2025 (paywalled).

Disclosure Note: Fisher Funds holds shares in CBA, NAB and ANZ in various portfolios

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