With banks under pressure following the downturn, Sanlam's Catherina du Toit looks at where is best to invest in these institutions.
Investing in emerging market banks has always been perceived as risky. But events of the past few years have caused investors to reconsider.
Going forward, the question is: where is the best opportunity for banks to grow and earn a good return on their capital, while engaging in their most basic activity, i.e. banking.
In the immediate future basic banking is likely to grow faster in selected emerging markets. Unfortunately, this is no longer a secret, so the next challenge is to gauge the resumption of growth in developed markets, and whether the valuations are cheap enough for the risks (mainly of low growth) that exists in what was once considered investment safe havens.
However, before deciding which region to invest in, investors need to understand three areas: loan growth, interest margins and bad debts.
To understand the valuation you need to understand the price/net asset value (P/NAV) and return on equity (ROE). The P/NAV indicates how much of what you are paying for the share is for future earnings. A P/NAV of 1x means you are paying only for what the bank is worth now, ie no future earnings growth.
Barclays is trading at a P/NAV of 0.85 at the moment – this indicates the market thinks there is a high possibilitythat it will generate losses for a few years (or have to issue more shares at a low value).
HDFC Bank in India is currently trading on a P/NAV of 4x. That is a lot of growth priced in. Our own experience over many years has taught us that the best time to invest in banks is when they trade at P/NAVs below 1x – ideally 0.6x. Banks trading at high P/NAVs have most of the good news priced in.
So, when you invest in a bank on a P/NAV of 0.6x, what must you look for?
- Does it have enough capital?
- What is the quality of its loan book, or more importantly:
- Does it have adequate reserves to cover possible loan losses?
- Will the economy grow again (an important condition for loan growth)?
Japan
Despite its banks trading below 0.9x P/NAV for many years, Japanese banks have been very poor investments. Why? Because the economy did not recover enough to generate good loan growth. At the same time, the low interest rate environment put pressure on interest margins that curbed their ability to generate high ROEs.
Emerging market banks have generally traded at P/NAVs above 1.5x but have been very good investments (there were a few occasions over the past 20 years where you could buy them at 0.8x and lower P/NAVs – which generated stunning returns for investors).
However, how do you decide what multiple to put on the NAV to get to a price investors will be willing to pay for the shares at a future date? Basically this multiple is determined by the ROE the bank is generating or what you reasonably think the bank can generate. ROE consists of return on assets (ROA) and gearing, ie the earnings the bank delivers from the assets it has on its balance sheet plus the gearing it applies to its equity.
To explain this in more practical terms (and also why emerging market banks do so well): On the earnings side, it is: strong loan growth (after each crisis emerging market loan growth quickly returns to 20% per annum and forecasts are also in this region); interest margins (in emerging markets they tend to be higher).
The reason for the strong loan growth is mainly the structural support provided by good economic growth as well as the low banking penetration and leverage/debt levels of both the retail and corporate markets. In Spain for example the household debt to GDP levels increased from 20%-30% of GDP during the 1980s to the current 80%-90% of GDP, while this number for India is still less than 15%. This explains why loan growth in emerging markets after each crisis can very quickly return to 20% per annum.
Interest margins
Emerging market banks have interest margins ranging from 5%-10% while banks in Europe, where the competition for deposits and lending is much more intense, have to survive on interest margins of 2%-4%.
This explains why developed market banks ventured into areas like sub-prime lending etc – to increase their yields and profitability… we are all aware of the outcome of this exercise.
Another reason for the higher margins in emerging markets is funding. Emerging market banks fund their loan growth through cheap deposits. Developed market banks have had to fund a lot of their loan growth via expensive wholesale funding.
Higher margins are often associated with more risk. It is thus important to ensure banks keep sufficient reserves to cover these bad debts if/when they occur. It is important to note though that these reserves can be very quickly depleted once an economic crisis strikes, one thus has to assess the risk in terms of available capital as well as the level of reserves.
Gearing
To overcome the low margins, banks in Europe/UK geared their capital more. In other words they wrote more loans for every dollar (or euro) of capital while emerging market banks, due to their high margins, never found it necessary to gear this much.
During economic downturns, the losses of UK/European banks were magnified relative to their capital, while emerging market banks survive downturns fairly well, as they had enough capital to cushion their losses.
Catherina du Toit is global financial analyst at Sanlam Investment
Management Global
