Why are financials so cheap?

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By Shaun le Roux

There is overwhelming consensus among local fund managers that the domestic financials, particularly banks, are cheap. They are almost certainly right, but may have to be patient before their overweight position pays off.

In global financial markets, financials have borne the brunt of the turmoil in equities. Small wonder. Giant global banks have taken massive hits to their balance sheets after they were forced to unwind some of their excessively lax lending of recent years in areas like sub-prime. The credit crisis that followed has resulted in the collapse of household names like Bear Stearns – in the company’s own words “a leading global investment banking, securities trading and brokerage firm since 1923”. Investment Banks have made huge amounts of money in the rather murky world of credit derivatives. We don’t know how the unleveraging of this minefield will play out, but what we do know is that they will not be making that sort of money anytime soon.

Nobody knows where we will find the bottom of the global credit crisis. After monumental US monetary and fiscal liquidity injections, a few pundits think we are almost there. It is possible that most of the share price pain in global financials is behind us, but it is much more likely that credit markets will remain tight and expensive for many months to come. This will be an environment in which banks find it much harder to make money. Furthermore, a lot of the lending of recent years has been encouraged by very low rates of interest and the accompanying bubbles in asset prices. We doubt that after a bubble of the magnitude of the US housing market is pricked, home buying and lending patterns will be able to return to normal levels less than a year later.

Turning to matters and markets closer to home, it is important to note that South African banks are hardly exposed to sub-prime, yet domestic credit conditions have tightened significantly. This directly impacts the margin that banks earn on their lending.

In addition, four-and-a-half percentage points of rate hikes are really starting to wreak havoc on the indebted part of the population, which is already reeling from significant increases in the cost of living. Bad debts in vehicle loans and credit cards are skyrocketing. Foreclosures on mortgage bonds are on their way and, if global property price movements are anything to go by, SA’s housing market must come under some pressure. Bad debts are rising and these eat straight into bank earnings.

It is worth remembering that banks, and other financial services businesses, have made a lot of money in areas other than lending in recent years. Increasing asset prices and low inflation resulted in very high levels of profitability in areas such as trading, private equity, broking and corporate finance. Inflationary pressures are now higher and returns from financial markets will be lower. We think banks will be hard pressed to build on 2007’s volumes and margins in investment banking and trading in the short term.

All this having been said, South African banks tend to have remarkably defensive income streams. 2007 may well prove to be the as-good-as-it-gets year, but as long as the economy keeps growing, bank earnings will grow with it. As the driver for economic growth shifts from consumer to infrastructural and investment spending, underpinning SA GDP, banks are set to gain on the corporate front while they hurt on the consumer front.

In the shorter term, bad debts are likely to squeeze profits but in the longer run banks will reap the benefits of tapping into providing consumer finance to the large previously unbanked population. In fact, this secular trend is common to most emerging markets and a bank like Standard Bank with its sizeable emerging-markets franchise in countries like Nigerian and Argentina is sure to benefit.

The alert reader will have noted that, despite the strong headwinds that exist in this space right now, the overall picture looking forward is rather attractive. The good news is that South African banks are trading as cheaply as they ever have, and valuation levels are definitely taking into account the issues that are likely to impact on earnings in the near future. The Banking Index is on a Price/Earnings ratio of 7 times last reported numbers and a historic Dividend Yield of 5.1%.

If previous cycles are anything to go by, the bottoming in ratings and relative performance will coincide with the peak in interest rates. With the Governor having raised rates last week and inflationary pressures remaining elevated, it is clearly too early to call the turning point – but we’re getting there.

We are confident that the banks are attractive long-term investments at current levels. We would be looking for a peak in inflation as an early indicator of the path for interest rates and at some point we expect to be aggressively long SA banks in our portfolios.

Source: Shaun le Roux, Alphen Asset Management, April 18, 2008.


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