This is a summary of an article by Portfolio Manager, Vaughan Henkel. We would highly recommend reading the full article on STANLIB.com, by clicking here.

Our investment in South African banks reflects the Absolute Return team’s philosophy and process behind identifying an opportunity for our clients.

Our process involves reviewing investments through six lenses:

• Economics
• Valuation
• Momentum
• Sentiment
• Volatility
• Liquidity

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. At its core, the thesis is:

• South African consumer outlook is poor, however…
• Banks’ share price performance has been extremely poor.
• Banks’ provisions are very large but 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.

We are not optimistic about the longer-term financial health of the South African consumer, given government’s fiscal challenges and the need to finance them, but we believe the current short/medium term outlook is too negative.

We note that bank stocks are traditionally value stocks, so they may also 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.

1.     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 specifically. About 80% of the personal loan book is derived from mortgage loans and instalment finance (mainly vehicles) which by definition are sought by higher-income clients.

Although the recent South African Quarterly Labour Force Survey (QLFS) shows 1.68 million fewer people were employed in Q3 2020 than in Q3 2019 (pre-COVID-19), we argue this will have a lesser impact on bank clients, as they are typically Decile 9 or 10 earners. The QLFS also showed 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.

The SA Reserve Bank (SARB)’s stability review showed that although household debt to disposable income rose rapidly from 73% to 85.3% during COVID-19, debt servicing costs as a percentage of disposable income remained at 9.4% as a result of interest rate cuts.

2.     Bank Provisions

Banks’ provisions were larger than during the GFC. This 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), appears that the provisions were more than sufficient. The resultant lowering of provisions in a single quarter supports the view.

3.     Potential losses if consumers default

It is clear consumers are under pressure from job losses, however 80% of the banks’ loan book is secured either by property (primarily houses) or by assets (primarily vehicles). Having assessed the potential losses of default on the banks’ mortgage, vehicle and general loans against the security that they hold, we believe that the earnings forecasts contain material upside. 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 decrease.

Valuation

There are numerous techniques to value banks. Price: earnings (PE) is a simple indicator and allows the widest comparisons across multiple sectors. Comparing 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.
• 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).

Momentum – Price and Earnings

A simple analysis of price momentum and earnings revisions is positive. 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).

Sentiment

The BoFA ML fund managers’ survey, which provides insight into the views of the majority of South African fund managers, 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. Relative to history, the view on banks is average rather than stretched in a positive manner.

Volatility

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.

Liquidity

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.

Conclusion

The Absolute Return team has a positive view on South African banks, based 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. While this offers limited value for the shorter term, it can lead to significant returns.
• Momentum, both price and earnings, is supportive. These indicators assist us in evaluating the opportunity from an entry point and from a risk management perspective.
• Neither sentiment, volatility nor liquidity is particularly risky for this investment at present.