Bank shares look cheap even as risks loom large

If evident only in their share prices, banks have had a tough time of things. And considering their exposure to a domestic economy struggling to keep its head above water, as well as tumultuous global financial markets, 2016 does not appear to be holding out any silver spoons for them.

Expectations are that the South African Reserve Bank (Sarb) will adopt a more aggressive interest rate hiking cycle in an attempt to mitigate the inflationary risks posed by an ever-weakening rand.

Hikes in the repo rate have an immediate positive impact on bank earnings, since they earn more interest on their capital, known as the endowment effect. But if these hikes prove to be successive and sharp, banks face the risk of higher bad debt charges as consumers and corporates struggle to repay their now more expensive debt.

Higher interest rates generally also mean slower growth in banks’ loan books, since debt becomes more costly and less attractive to consumers.

Although bank shares were hammered by the finance minister shuffle (and this can’t have been pleasant), a greater concern is over what happens if South Africa’s credit rating is downgraded to junk status by major ratings agencies.

The below graph reflects the share price movement from 2011 to January 12 2016 of FirstRand (light blue); Barclays Africa (red); Nedbank (green); Standard Bank (blue); and Capitec (white). The number on the right-hand side is the aggregate percentage return over five years.

Source: Bloomberg

If this does happen, bank credit ratings will follow suit since the rules of ratings agencies dictate that no domestic company can have a credit rating higher than the government under which it operates.

Currently, Fitch and Standard & Poor’s both have South Africa one notch above sub-investment grade (Moody’s has us one notch above that), with looming concerns over a downgrade in the next six to 12 months.

In the short-term, banks can probably rely on their pool of deposits and domestic investments, but it’s likely to increase their cost of funding over the long term.

Buy or sell?

Despite this rather gloomy outlook, a number of fund managers believe markets have already priced these risks in and that banking shares are cheap – perhaps even oversold – relative to their dividend yields.

“The banking sector is trading at nine times earnings in a market that is nearly double that,” says Lonwabo Maqubela, portfolio manager at Perpetua Investment Managers

All of the Big Four banks are trading at single-digit forward price-to-earnings (PE) ratios, suggesting that the market is not expecting massive earnings from banks over the next year but also that they may well be undervalued.

On 6-7% dividend yields, banks are very attractive, argues Maqubela, who says these yields can be sustained due to adequate levels of capital.

These returns are also being achieved on earnings that are not extremely high, adds Andrew Lapping, portfolio manager at Allan Gray. “Even if banks grow earnings in line with inflation only, they’ll be delivering real returns in the region of 5% to 7%, which is excellent in the global scheme of things,” he says. “I think banks are very cheap.”

While Lapping acknowledges that there’ll be downward pressure on revenues in a slowing economy, he argues that banks are going into the downturn in a very different position to where they were in 2007/2008.

They are better provisioned for bad debts and growth in advances, particularly mortgages in recent years, has been modest in comparison.

“If the weak economy leads to a banking crisis in some emerging markets, I think our banks should be able to hold up relatively well,” comments Renier de Bruyn, investment analyst at Sanlam Private Wealth. He believes our banks are feeling the pain of a general risk aversion to emerging market banks, despite having stricter credit criteria and a private sector that is deleveraging.

De Bruyn adds that banks can also reduce cost structures, by moving increasingly to digital channels and away from sprawling branch networks, which will offset some of the expected revenue pressures.

Add to this strong management teams and room for innovation, and banking shares may look cheap. That is, if markets have indeed priced risks to the South African economy into these shares.

“I don’t know whether a rand at R16.60 has been fully factored in, we’ve only had it for two weeks,” cautions David Shapiro, deputy chairman of Sasfin Securities. “Don’t be optimistic because you feel like being optimistic, be optimistic because you’ve worked it through.”

Either way, Shapiro advises ‘not holding your breath’ for a massive increase in banking profits, suggesting that around 12% earnings growth will be good at these P/E levels.

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