Banking sector investments: idea and process – Full Article
The Absolute Return team holds a positive outlook on South African banks, based on the following factors which we unpack below:
The fundamentals for banks offer support in the context of job losses, provisions and interest rate cuts.
Bank valuations are cheap relative to their history and to the ALSI.
Momentum, both price and earnings, is supportive.
Neither sentiment, volatility nor liquidity is currently cause for alarm.
Consequently, our funds hold a position in banks, but we continue to evaluate the above factors regularly to determine whether anything in this investment thesis has changed.
What follows is an indication of the analysis that must be followed and, given its complexity, we are offering only a brief summary, rather than an exhaustive analysis.
South African Banks
Our investment in South African banks reflects the Absolute Return team’s philosophy and process towards identifying an opportunity for our clients.
Our process involves reviewing investments through six lenses:
We will examine the banks investment thesis using our six lenses to illustrate how we reviewed the opportunity and took the decision to include it in our portfolios.
SA banks investment thesis – review of the consumer book (c50% of the credit book):
Our initial view was predicated on a “back to some form of normalcy” likelihood in client behaviour (credit growth, bad debt provisions and credit experience) coupled with the banks’ credit loss ratio being almost 20% above the level during the 2008/9 Global Financial Crisis ([195 bp forecast for 2020E during July 20] across the Big Four banks against 165 bp in the GFC – see chart below). At its core the thesis is:
South African consumer outlook is poor, however…
Banks’ share price performance has been extremely poor.
Banks’ provisions are extremely large and are primarily backed by assets (houses, cars and other assets), which limit the actual losses banks can suffer.
The outcome will be less severe than early forecasts, which are invariably extreme.
Earnings will be revised upwards as the outcome becomes less negative.
This analysis is consumer-focused. The other 50% of the banks’ credit book (the corporate book) has not been analysed in this note but a similar strategy is followed in the research process.
Finally, we caution that we are not optimistic about the longer-term financial health of South African consumers, given government’s fiscal challenges and the need to finance them, but the current short/medium term outlook is too negative.
We do not offer an opinion on the current debate of value versus growth, but note that bank stocks are traditionally value stocks, so they may benefit from style rotation, which is currently front of most investor’s minds.
Economics (fundamental view)
The current environment is extremely challenging for countries and consumers as a result of the COVID-19-induced lockdowns and their economic impact. The Absolute Returns team has to evaluate the opportunity in the context of the price action and determine whether this is an opportunity or a poor investment.
Starting with the fundamentals, we need to have a view on four areas, which relate primarily to the personal loan book (c50% of banks’ credit books):
We must have a view on the financial health of the consumer as a result of jobs and wages.
We must review the credit loss provisions already made by banks.
The interest rate cuts have made debt servicing costs significantly cheaper.
We must have a view on what the banks may lose, if there are defaults on loans (loss given default or LGD).
The outcome of these four key insights delivers an expectation of earnings, on the basis that, simplistically, valuation = earnings x ratings.
Consumer Income – wages and jobs
While SA faces the well-known challenge of a high unemployment rate of 30% (even higher if using the expanded definition), we focus on banking clients in particular. About 80% of the personal loan book is derived from mortgage loans and instalment finance (mainly vehicles) which are by definition sought by higher-income clients. We therefore investigate:
The recent Quarterly Labour Force Survey (QLFS) shows 1.68 million fewer people were employed in Q3 2020 than in Q3 2019 (pre-COVID-19). This is clearly a huge challenge for the country. Only 34% (580 000 people) hold a secondary qualification or greater.
Our contention is that this will have a lesser impact on bank clients, as they are typically Decile 9 or 10 earners and we are using the qualification criteria from the QLFS as a proxy for income. Indeed, of the 3.3 million people with tertiary education, only 231 000 (6.5%) have lost employment, according to the QLFS.
The QLFS also provided information on the level of wages received during lockdown and the education level of those receiving salaries (we use this as a proxy for income levels). The key takeaways are:
3% of people employed continued to receive pay.
9% of those paid received reduced salaries.
That means 70% of people employed received full pay, and a further 17% received partial pay, totalling 87.3%.
9% of graduates received full salary and 79% of people with less than matric received full salary.
The vast majority of highly-skilled workers received full pay, so they would be able to service their debt levels, particularly since the interest rates have been cut by three percentage points, making the interest charge on their debt significantly more affordable (see next point).
Interest rate cuts – supporting lower debt servicing costs even though debt increased after employment and wages, we reviewed the debt levels of households and more importantly debt service costs, to obtain an indication of stress on clients. We next looked at banks’ provisions for losses and LGDs, if the picture was extremely bleak.
Using the SA Reserve Bank (SARB)’s stability review for a picture of the SA consumer, we note:
Household debt to disposable income rose rapidly from 73% to 85.3% during COVID-19 but…
Debt servicing costs as a percentage of disposable income remained at 9.4% as a result of the SARB’s interest rate cuts.
Household debt-to-disposable income and debt-service costs
Our conclusion was that household stress as a result of debt servicing costs did not change (in the short term, while interest rates remain low).
Bank Provisions – credit loss provisions made
Banks will proactively provision for losses that they expect and more so now they have adopted IFRS 9 (International Financial Reporting Standards), which requires them to forecast losses in the current environment or value financial instruments (this is a simplistic explanation of an extremely complicated process).
Banks’ provisions are higher than in the GFC and we must determine whether this is too conservative or appropriate. We noted:
- 87% of employed people received their wages during the crisis.
- Interest rates were cut by three percentage points, making debt servicing costs (see prior point) significantly cheaper.
- 80% of personal debt is secured by a house or a vehicle (see later).
- Central banks and governments have responded with large measures of support.
- There are now various COVID-19 vaccines, so the economy will re-open and start to recover.
We see below how the forecast of banks’ provisions has already moderated (HSBC forecasts, indicative of analysts’ forecasts).
While it is beyond the scope of this article to unpack the detail of provisions, the fact that the provisions are larger than during the GFC in the context of the massive global support and shorter-term impact of the crisis (governments were quick to shut economies globally and relatively quick to open them again), it appears that the provisions were more than sufficient. Obviously, there is an element of hindsight in this view and this cannot be analysed perfectly, but the resultant lowering of provisions in a single quarter supports the view.
Potential losses if consumers default
It is clear consumers are under pressure from job losses, however three areas are more relevant (collectively > 80% of the banks’ personal loan books):
Personal loans (c50% of the banks’ credit books)
Home loans (c60 % of the personal credit books)
Instalment sales (largely vehicle loans – c20% of the personal loan books)
General loans (c20% of the personal loan books)
Corporate loans (c50% of the banks’ credit books)
We therefore have to review the LGD for the banks collectively.
80% of the loan book is secured either by property (primarily houses) or by assets (primarily vehicles).
For mortgages, 79% of loans were originated at LTV (loan to value) below 100% during 2017-19 and, with house price inflation running at c5% over the past five years (SARB Financial Stability Review page 78), 80% of loans have LTV ratios below 80% (FSR page 79). That means the LGD should be limited, as the realisable asset should generally exceed the loan.
Bank credit extended and share of credit by credit type
We do not have the same level of detail for vehicles, but the banks have been largely conservative in the issuance of these loans and a similar calculation would be appropriate. Although there are higher levels of LGD, the interest rate charged compensates for this higher level of risk.
General loans carry the highest level of provisioning, since the security is not asset-backed.
It must be noted that this is a summary of a complicated topic. The SARB releases the Stability Review twice a year and it contains a very extensive analysis of the risks banks face. The latest version was released in November 2020 and we have used some of the data and analysis to inform our views.
Earnings outlook – result of the three factors above
Having reviewed the four key factors of
Jobs and wages
Loss Given Defaults
We believe that the earnings forecasts contain material upside risks, since on average the Big Five banks (including Capitec) at mid-2020 hold provision levels at 90% of the profit for these banks. As noted previously, forecasts of these provision levels are already starting to decline.
There are numerous techniques to value banks. Two of the best-known are Price to Book multiples and Price Earnings (PE). We will show PE, because it is a simple indicator and allows the widest comparisons across multiple sectors.
The chart below shows the PE of financial shares (largely banks) against the ALSI PE. We note:
Although the Financials PE has re-rated from March 2020, it is still lower than its history, excluding the GFC and the 1997/8 Asian and Russian crises.
The black line is the relative valuation (Financials PE/ALSI PE) and indicates that relative to the broader ALSI Financials are the cheapest they have been since the GFC and at the end of 2015 (after Nenegate, when SA’s Finance Minister was removed).
Although valuation is more useful for a longer-term horizon and is not a good short/medium term investment indicator, the stretched nature of its undervaluation can lead to rapid and significant performance (there were four historical occasions when PE < 0.6x ALSI PE, all of which provided significant return) when it turns.
Momentum – Price and Earnings
It is beyond the scope of this piece to delve in depth into the detail of the momentum factors. A simple analysis of price momentum and earnings revisions is supportive, for the following reasons:
Using moving averages, we note that the Banks Index is now above its 200-day moving average and shorter moving averages are supportive.
The JBNKS Index (Bloomberg Index of Banks) has now turned positive in terms of three-month earnings revisions (December 2020). We also note that the change in earnings revisions (although still negative before November) was trending upwards from the lows in May of 2020 (Source: Bloomberg).
Fund Managers survey – BoFA
To determine sentiment towards banks, we used the BoFA ML fund managers’ survey, which provides insight into the views of the majority of South African fund managers. It showed managers are c10% overweight banks, which is in line with the historical average (South African managers generally favour banks over time). Historically, this indicator ranges between 5% and 20% overweight.
We concluded that relative to history, the view on banks is average rather than stretched in a positive manner.
South African volatility is 20.2% (three-month at-the-money implied), which is 0.4 standard deviations above average (five-year average), so it is slightly elevated but not materially so. This is down on a three- and six-month basis.
Bank liquidity is more than adequate for most funds to transact, as this is a large and liquid sector. For example, the market cap of the Big Four South African banks ranges from R59 billion for Nedbank to R258 billion for FirstRand.
The Absolute Return team has a positive view on South African banks, which is predicated on the following factors:
Fundamentals for banks offer support when evaluated in the context of job losses (limited upper end), wage experience for the upper income consumers having limited negative impact, bank provisions being extremely large relative to history, three percentage points of interest rate cuts and a positive view on the loss given default expectations.
The valuation for banks is cheap relative to history and relative to the ALSI index, and while this is of limited value for the shorter term, it can lead to significant returns, as demonstrated by four periods in history, where the valuation were similarly cheap.
Momentum, both price and earnings, is supportive and these indicators assist us in evaluating the opportunity from an entry point and also from a risk management perspective.
Neither sentiment, volatility nor liquidity is particularly risky for this investment at present.