Wall Street wipes the floor w Ith Sandton
Performance of US banks makes the returns from most of their local counterparts look like chump change, writes
US banks have been a potent investment in the past five years, with a cursory look at Wall Street’s biggest banks revealing solid returns — unless you had the misfortune of owning shares in Citigroup. As always, diversification is your friend.
In contrast, Capitec has been the only great investment over the past five years among local banks. Ironically, given its branding, Absa is the only other bank that isn’t in the red over that period. This is before we even take into consideration the depreciation of the rand against the dollar. Expressed in dollar, the returns are hideous.
If you are looking to build wealth by global standards, then almost all the local banks have been awful. To really shock you, Capitec’s marketcrushing 10-year compound annual growth rate of 25% in rand equates to only 17% in dollar. Let’s face it: picking Capitec over that period and hanging on for the ride would’ve required an exceptional stock-picking strategy and immense discipline.
Instead, you could’ve achieved a compound annual growth rate of 15.6% in Morgan Stanley — not far off Capitec for a “buy and forget” bank that would hardly have given you any grey hairs.
Let’s face it: it’s more likely that you would’ve held Morgan Stanley throughout that period than Capitec, given the relative risks. Hindsight is always perfect when it comes to “Yes, of course I would’ve held my shares through that crisis”.
It isn’t news to anyone that South Africans became poorer in global terms over the socalled lost decade, a period which is starting to look like a lost 15 years (or longer). The trouble is that banks are inextricably tied to the economies in which they operate. Leading banks are lumbering giants that struggle to differentiate themselves, which means growth is difficult to come by unless the broader economy is growing.
The reason Capitec looks great over 10 years, even in dollar terms, is that it took substantial market share from competitors. It grew despite the macroeconomic realities, not because of them, winning a larger piece of a pie that barely increased in size. This is why investors cannot ignore the macroeconomic picture when taking longterm positions in banks.
To assess the value of a bank, the best metric is priceto-book (p:b), as the book value (or NAV) per share is the difference between assets and liabilities, both of which are carried at fair value.
This is different from industrial businesses, in which the assets are carried at depreciated historical cost (often far below current fair value). In a balance sheet where almost everything is at fair value, the book value is a useful indicator for what the equity (owned by shareholders) is really worth.
This doesn’t necessarily mean that a bank should trade at one times the book value. A major driver of the valuation multiple is return on equity (ROE), which measures how successfully the bank uses that book value in generating returns for shareholders. If the cost base is too high and returns are poor, the market will buy that equity at a discount to book value to reflect the subpar management team. Conversely, ROE in excess of the cost of equity will drive a premium to book value.
Among the major local banks, Capitec trades at the highest p:b by miles, averaging 6.6 times over the past 10 years. The latest level is around 5.8 times, so even a year of exceptional growth and a clearly deteriorated economy haven’t dampened investors’ spirits.
This multiple has been driven by Capitec’s growth prospects rather than its ROE, which is a useful reminder of another major driver of the valuation. It’s also an indication of the risks investors face when they pay a growth multiple for a South African bank. When much of the upside is priced in, the risk-return profile becomes unappealing.
The next highest in terms of valuation multiple is FirstRand, which tends to trade at two times book value. The other three major banks tend to trade at between 1.2 times and 1.5 times.
Surprisingly, US banks paint a different picture. Over a 10-year period, the average p:b of Morgan Stanley, Goldman Sachs, JPMorgan and Bank of America has been between one times and 1.4 times. The latest levels have seen Morgan Stanley pull ahead to 1.8 times still well below FirstRand and in a different postal code to Capitec.
This means you can pay a
SA banks have been playing a defensive game for the past decade
lower multiple for US banks than their local counterparts. Instead of investing in a land of load-shedding and anaemic economic growth, you can invest in the most powerful Western economy. Aside from the obvious difference in the underlying economic realities, you also get the benefit of an investment denominated in dollar.
This all begs the question: why invest in local banks? Is there a growth driver that could surprise the market and drive outperformance vs global counterparts?
Bulls may say we are at a point in the interest rate cycle that is kind to our banks.
Rates are high but not ridiculous, which allows banks to really maximise the net interest margin earned in the core lending business.
Remember, the core business of any bank is to borrow cheaply and lend for a much higher rate, managing credit losses and expenses along the way. When interest rates are higher, net interest margin expands. The reason is simple: though the lending rate increases, the bank doesn’t match that increase on what it pays for deposits in current accounts and shortterm money market accounts.
Did you see your current account deposit rate increase by 375 basis points since mid2020? Us neither. But if you have a home loan, your interest rate will have increased every time prime increased (unless you took a fixed-rate package, in which case the bank loves you even more than usual).
There’s a point at which rates are so high that credit losses start to offset the benefit of higher margins, and banks tend to give the market fair warning of this by commenting on through-thecycle credit losses and where the expectation is vs the target range.
As lending conditions deteriorate, banks tighten criteria and sacrifice asset growth in pursuit of a reasonable credit-loss ratio. When times are good, they loosen up and lend with more confidence, driving asset growth without breaking the credit book.
Notably, inflation drives larger balance sheets and that means higher demand for credit by companies and individuals. A combination of inflation and higher rates is bullish for banks, provided borrowers can afford to repay the debt.
To supplement the lending business, banks chase noninterest revenue through activities such as investment banking advisory services, trading desks, wealth management operations and insurance businesses. The intention is to generate profits from intellectual capital rather than financial capital, a massive uplift for ROE. When you can get the R without the E, shareholders are smiling. Those smiles lead to a higher p:b multiple.
Again, SA isn’t an easy place for this strategy. In the US, banks such as Goldman Sachs make a fortune from equity and debt issuances. They offer services such as underwriting and marketmaking alongside advisory, getting a clip on the deal tickets in the most vibrant capital markets in the world. On the JSE, most investors would be forgiven for thinking an IPO is some kind of ESG reporting format. The closest we get is a rare accelerated bookbuild.
The net impact is South African banks have been playing a defensive game for the past decade, with the exception of Capitec’s crusade to win market share with a lower-cost offering. The other banks have been squeezed by Capitec on one side and South Africa’s poor economic performance on the other, with horrible long-term results for shareholders.
Even Capitec’s best days are probably behind it. The efficiency (or cost-to-income) ratio has come under pressure recently as expense growth outpaced revenue growth, a worrying sign for a bank trading on a huge p:b multiple. With a push into services such as business banking, an argument can be made that Capitec is starting to find it more difficult to win market share in its core operations. At some point, the growth rate is likely to fall in line with peers. When that happens, I wouldn’t want to be holding Capitec at a high valuation multiple.
Long-term issues aside, you can still be opportunistic with local banks. Over the past year the laggards were the leaders, with solid returns from Standard Bank, Nedbank and Absa. FirstRand was flat and Capitec suffered a 15% drawdown as the valuation multiple looked too hot for the market. The value trade was the clear winner here, with high growth multiples being more sensitive to the economic realities banks face.
The local challenges don’t mean global banks offer perfect alternatives. Wall
Street cowboys are famous for being fined eye-watering sums for bad behaviour, something we rarely see in South Africa. And some banks are run for the bankers rather than the shareholders, with Goldman Sachs especially guilty of paying staff a fortune in good times and bad.
Over the long term, though, history shows us a clear winner. Wall Street has been kinder to your money than Maude Street.