Shares to bank on as retail cycle slows
But food companies could still be good
ASTUTE FUND MANAGERS have been buying local banks, especially the big four banks, often at the expense of retailers. Rising interest rates suggest it’s the right move. But there are longer-term investment implications to this portfolio rotation. And perhaps there’s still space for some retail shares, particularly those that don’t work on a credit basis.
Allan Gray has been buying financial shares, particularly banks, and has not reestablished the retailers that made up a significant portion of portfolios from 2001 to 2003. But as a deep value investor Allan Gray must be looking beyond obvious short-term attractions. Portfolio manager Duncan Artus says banks’ current relative valuations are attractive and “do not reflect our expectation that their earnings should outperform retailers and the market from current levels”.
Much of the thinking is based on the way retailers’ sales and banks’ advances, both exceptionally strong over the past few years as interest rates declined, are translated into bottom line profits.
For the credit retailer, says Artus, the sale is reflected on the income statement fairly quickly, as the gross profit (the dominant contributor) and interest received on the outstanding sales amount are mostly realised in the year the sale is made.
In contrast, he says banks’ asset-backed advances (about 60% of local banks’ lending) stay on the balance sheet for several reporting periods (around three to seven years) and contribute to revenue in interest and fees.
So apart from banks’ asset-backed lending being more secure than retailers’ credit, the benefits continue to flow in after a favourable environment, as banks and retail- ers have enjoyed, starts to slow. Artus points out that due to retailers’ more cyclical profits, these businesses tend to be relatively more profitable in the good times and banks underperform in earnings and share prices – hence the attractive valuations now.
There should also be a further boost for banks. “We believe that as the retail cycle slows, banks’ earnings will be underpinned further by a significant increase in corporate lending,” Artus says.
Many companies have enjoyed little debt and large cash holdings, not needing additional funding from banks. But Artus believes the growth in business activity means that many companies are operating close to peak capacity and will need to embark on significant capital investment programmes to increase capacity and cope with higher levels of demand. “It’s reasonable to assume that the banks will fund a material portion of this expansion in capacity,” says Artus.
Other possible benefits he points to from this include increased revenue streams for merchant banking divisions.
The argument certainly makes banks look like a good investment now relative to retailers, and perhaps some industrial counters as well as margins could come under pressure due to the lag between increasing capacity and meeting demand.
However, we wouldn’t rule out the nonor limited credit retailers, typically the food retailers like Pick ’n Pay and Spar. The probable delisting of Shoprite could add to the attraction of these shares.