Why SA bank shares

will with­stand the Euro­pean whirl­wind

Financial Mail - Investors Monthly - - Front Page -

Fears of a re­treat to the dark days of the 2008 fi­nan­cial cri­sis has in­vestors run­ning scared. Just as South African banks were re­cov­er­ing from the thrash­ing they took af­ter the fir­ing of Nh­lanhla Nene as the coun­try’s fi­nance min­is­ter, it looks like all bets are off again.

The FTSE/JSE banks in­dex fell 13.5% on De­cem­ber 10 — a day af­ter Nene was re­moved from of­fice. It tum­bled a fur­ther 6% the next day, be­fore stabilisin­g in the last days of 2015 as Pravin Gord­han’s reap­point­ment soothed the mar­kets. Nev­er­the­less, by mid-Fe­bru­ary, the banks were still trad­ing below pre-Nenegate lev­els.

Of course, it can’t all be blamed on lo­cal pol­i­tics or on the loom­ing threat of a sov­er­eign down­grade. Fact is, it’s been a tor­rid start to the year for banks across the globe.

The STOXX Europe 600 Banks in­dex had lost a fifth of its value by early Fe­bru­ary. Con­cern over the strength of bal­ance sheets, ex­po­sure to the weak­ened re­sources sec­tor, zero to neg­a­tive in­ter­est rates and a gen­eral risk-off mood has brought a shift out of eq­ui­ties into gold and top-rated debts. And banks have borne the brunt of this sell-off.

“Clearly, were there to be a col­lapse of any global sys­tem­i­cally im­por­tant fi­nan­cial in­sti­tu­tion, that would have reper­cus­sions way be­yond what any­body can an­tic­i­pate,” says Chris Stew­ard, head of fi­nan­cials at In­vestec As­set Man­age­ment. “SA banks com­fort­ably nav­i­gated the pre­vi­ous cri­sis, and would do so again [if an­other one oc­curred] as they are in bet­ter shape now than they were then in terms of cap­i­tal, pro­vi­sion­ing and the qual­ity of their bal­ance sheets. But it would nev­er­the­less have a rat­ings im­pact on fi­nan­cial ser­vices com­pa­nies [glob­ally].”

This sour mood is why, de­spite the re­cent sell-off, an­a­lysts aren’t pre­dict­ing any big re­cov­ery in share prices any­time soon. Of all the JSE-listed banks, In­vestec is the sweet­heart right now. All 9 an­a­lysts polled rate it a “buy”, putting a tar­get price of R130.57 on In­vestec PLC — 28% above its cur­rent lev­els of around R101.

Of the big four retail banks, FirstRand and Bar­clays Africa seem to be the favourites.

FirstRand has eight “buys” and seven “holds”, though the tar­get price it ex­pects for the stock is R46.37 — just 1.6% above its cur­rent level. Bar­clays Africa has an even split of seven “buys” and seven “holds”, but the tar­get price is R151.31, just 0.8% above its cur­rent R150.15.

Ned­bank has six “buys”, eight “holds”, one “sell” and an ex­pected tar­get price of R199.55 — 4.5% above its cur­rent level. There’s less op­ti­mism about Stan­dard Bank, with an­a­lysts roughly split, and just a 1.9% up­side on the tar­get price.

But if the mood dark­ens in Europe, and glob­ally, even th­ese pre­dic­tions may prove to be too op­ti­mistic.

The main is­sues in Europe in­clude lower than fore­seen earn­ings, largely be­cause Euro­pean in­ter­est rates are now ex­pected to stay lower for longer.

This will keep bank mar­gins de­pressed, says Ned­bank CEO Mike Brown.

Throw in the fact that weak com­mod­ity prices have put pres­sure on oil-de­pen­dent coun­tries, and you have all the mak­ings of a hor­ror show.

Many of th­ese coun­tries bor­rowed from global banks when oil prices were north of US$100/bar­rel. To­day, with oil prices ebbing at around $30/bar­rel, banks are fac­ing the risk of ris­ing im­pair­ments and de­faults. There is now spec­u­la­tion that a small num­ber of Euro­pean

We would not ex­pect a Euro­pean bank, and cer­tainly not a large one, to fail in the cur­rent en­vi­ron­ment

banks may not be able to re­pay their coupons on new-style Al­ter­na­tive Tier 1 cap­i­tal in­stru­ments. Th­ese in­stru­ments in­clude Con­tin­gent Con­vert­ible bonds, known in short­hand as CoCo bonds. They’re not new, but they sud­denly have in­vestors very wor­ried in­deed.

CoCo bonds have been widely used in Europe to boost cap­i­tal to meet the stricter re­quire­ments since the 2008 crunch. They work by hav­ing dis­cre­tionary in­ter­est pay­ment clauses, so that in­ter­est can be with­held. Bloomberg de­scribes them as high-yield in­vest­ments with “a hand grenade at­tached”.

CoCo bonds are al­most a cross be­tween a stock and a bond, but they can also be con­verted into equity in the is­su­ing bank. It’s risky busi­ness, but in a yield-hun­gry world and with de­vel­oped-world in­ter­est rates of­fer­ing lit­tle, there has been enough up­take to cause con­cern.

In SA, only In­vestec of the big five banks has is­sued an AT1 in­stru­ment, but for­tu­nately for them, it’s not a CoCo bond.

Ned­bank’s Brown doesn’t think there’s rea­son to be too wor­ried, how­ever. “We would not ex­pect a Euro­pean bank, and cer­tainly not a large one, to fail in the cur­rent en­vi­ron­ment,” he says. “This is due, among other things, to the im­ple­men­ta­tion of the reg­u­la­tory en­hance­ments since the global fi­nan­cial cri­sis.”

Stew­ard agrees that banks’ bal­ance sheets are gen­er­ally in bet­ter shape that they were be­fore the global fi­nan­cial cri­sis, even if in­vestors are still tak­ing a dim view of fu­ture prof­itabil­ity.

“There are con­cerns about the en­vi­ron­ment they are op­er­at­ing in and their abil­ity to gen­er­ate de­cent re­turns,” he says. “There are also con­cerns about what is go­ing to hap­pen to mon­e­tary pol­icy glob­ally.”

But even if a small­ish Euro­pean bank were to go un­der, Brown says, there should be very lit­tle di­rect spillover into the SA bank­ing sys­tem.

Ned­bank’s ex­po­sure to banks in Europe is gen­er­ally through ex­cess funds placed overnight with sys­tem­i­cally im­por­tant banks in in­vest­ment-grade sov­er­eigns. Brown says that th­ese coun­ter­par­ties are re­viewed reg­u­larly and ex­po­sure is of a short-term na­ture.

Stew­ard says SA banks are in a some­what dif­fer­ent space from their de­vel­oped-mar­ket peers. They are bet­ter matched, in the sense that they source their fund­ing in the short-term mar­ket and also lend off rel­a­tively short-term ref­er­ence rates.

“We are in a dif­fer­ent mon­e­tary regime, with ris­ing in­ter­est rates which, while pos­si­bly pos­i­tive for mar­gins, will have a neg­a­tive ef­fect on credit qual­ity,” he says. “The big­gest con­cern is that the SA Re­serve Bank might be forced into a se­ries of de­fen­sive rate hikes to pro­tect the cur­rency and pre­vent the se­cond-round ef­fects of cur­rency weak­ness on in­fla­tion.”

While in­ter­est rate hikes are pos­i­tive for banks’ mar­gins, the dan­ger is that they could lead to a sharp drop in credit qual­ity.

A 100 ba­sis point hike in in­ter­est rate this year would prob­a­bly be man­age­able, but Stew­ard says more than that would be bad for the banks.

“There is no doubt they are in a tough space; this is go­ing to be a dif­fi­cult year,” he says.

Un­like some other an­a­lysts, Stew­ard doesn’t be­lieve banks are par­tic­u­larly cheap at cur­rent val­u­a­tions. Rather, he says the mar­ket’s ex­pec­ta­tions for earn­ings growth for this year re­main too high. “Mar­ket fore­casts ap­pear to fac­tor in earn­ings growth of about 10% this year, but I think the banks will do well to pro­duce flat earn­ings,” he says. “I worry that ex­pec­ta­tions are still too el­e­vated.”

With banks gen­er­at­ing re­turns on equity in the mid teens — around the same lev­els of in­vestors’ cost of cap­i­tal — he says val­u­a­tions of 1.5 times book value aren’t par­tic­u­larly en­tic­ing.

“They have rea­son­ably at­trac­tive div­i­dend yields, which in most cases are prob­a­bly sus­tain­able to within 10%,” he says. “If earn­ings do go down, then div­i­dends might too, with the ex­cep­tion of FirstRand and Stan­dard Bank, which have de­cent cap­i­tal buf­fers they could dip into.” A sov­er­eign down­grade would be neg­a­tive, but Stew­ard says SA banks have an ad­van­tage over their emerg­ing-mar­ket peers as their bal­ance sheets are largely rand based, with lit­tle for­eign cur­rency ex­po­sure.

SA banks also don’t have the same sort of ex­po­sure to com­mod­ity prices as their Euro­pean coun­ter­parts. Harry Botha, a banks an­a­lyst at Av­ior Cap­i­tal Mar­kets, reck­ons only 2% to 5% of the as­sets of lo­cal banks are ex­posed to com­modi­ties. While this sug­gests they’re still likely to face some credit losses in the next few years, Botha doesn’t see this reach­ing cri­sis lev­els.

“In the global fi­nan­cial cri­sis, the big four SA banks’ in­come state­ment credit losses were more or less dou­ble 2015 lev­els,” Botha says. “We es­ti­mate this is priced into banks’ share prices and be­cause we do not ex­pect credit losses to this ex­tent we find SA banks cheap at cur­rent lev­els.”

Cheap maybe — but that’s for a rea­son, says Paolo Se­na­tore, chief in­vest­ment of­fi­cer at Ash­bur­ton. He says: “The South African con­sumer is likely to come un­der pres­sure.” In­vestors have be­come quite used to banks re­port­ing growth of 15%-20% in earn­ings per share, but this is more likely to be around 8%-10% in fu­ture, he says. “So, while a price:earn­ings ra­tio of 10 looks cheap, it’s re­flect­ing earn­ings for the next year or so.”

The best-case sce­nario for the worst-rated banks such as Bar­clays Africa and Stan­dard Bank, says Stew­ard, would be if govern­ment does all the right things from a pol­icy per­spec­tive, the mar­kets re­sume a risk-on rally and the cost of cap­i­tal starts to fall. But in a tougher en­vi­ron­ment, Stew­ard would stick to the likes of FirstRand. While FirstRand might trade at a higher mul­ti­ple, it gen­er­ates su­pe­rior re­turns, has a more con­ser­va­tive bal­ance sheet and is bet­ter cap­i­talised.

Av­ior’s Botha prefers Stan­dard Bank and Ned­bank on a to­tal re­turn ba­sis.

But, if you’re af­ter the low­est com­mod­ity ex­po­sure with a rea­son­able re­turn, then FirstRand would be top, he says.


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