Glen Finegan, Head of Emerging Market Equities, believes that the banking sector within his asset class now offers investors interesting long-term investment opportunities. Glen explains the types of banks that he is currently targeting and the areas to avoid.
Shares in many banks across the emerging markets universe performed poorly in 2015. The highly-leveraged nature of a bank’s balance sheet combined with the increased risk of bad loans during times of economic stress makes this a difficult sector for investors who prefer to sleep well at night.
Rules of engagement
We have some simple rules when looking for banks that meet our quality criteria. We favour private control over state control. We also look for banks with relatively simple savings and loans operations that have scope to grow via increased penetration of products and services. Complex trading operations are a warning sign. We like a low ratio of loans to deposits and prefer banks that generate profits from a reasonable return on their assets rather than excessive leverage to boost return on equity. We are also sceptical that banking is an international business and tend to favour single country specialists over those with global ambitions.
Avoid state-controlled banks
Many emerging market governments view banking as a strategic function and want to be in the business. We do not believe governments make good bankers because their banks tend to be excessively bureaucratic and are often policy tools forced to support strategic but not necessarily productive sectors of the economy. Also, government banks are regularly embroiled in political corruption scandals; history has shown that when politicians are allowed in the credit department it rarely ends well.
In contrast, shareholders’ equity at a privately-controlled bank often represents individuals’ wealth, meaning they are more likely to lend to clients they believe will pay them back and attempt to price risk sensibly. Private owners are also likely to hire effective professional managers and put in place incentives focusing on risk-adjusted returns rather than dangerous concepts such as market share or loan growth targets. Often too, the best-quality clients prefer dealing with like-minded private sector bankers rather than bureaucrats.
We look for well-managed private banks with track records of successfully managing risk through good times and bad. Banks can be a bit like wine - a good-quality bottle usually costs more but is far less likely to leave you nursing a hangover after the party inevitably ends. We try to stick to the good stuff.
Fortunately, across the developing world we are finding a number of private banks that meet our criteria.
India’s scope for growth
According to Asian investment research house CLSA, as at the year ending March 2015, government-related banks in India controlled almost three quarters of total bank assets in the country. The remainder was split between local private banks and some foreign players. We believe the better run private banks will continue to take market share from their government-owned peers and that at some point this ratio will be reversed.
Indian mortgage finance company HDFC trades at a significant premium to its largest state controlled peer State Bank of India (SBI) but the difference in track records is stark. Over the last ten years HDFC has grown its book value per share plus dividend nearly twice as quickly as SBI. Despite this, mortgage loans to gross domestic product in India remain low, leaving scope for continued growth. HDFC is one of our strategy’s top-ten holdings.
Low oil prices are causing concerns for some areas of the financials sector. Egypt’s Gulf-based benefactors, for example, may be forced to reign in financial support. Despite this, Egypt remains home to one of the best run banks in our investment universe. Commercial International Bank, listed in Cairo, has an excellent track record of managing risk and still has huge scope to grow assets from a very low base. During November 2015 we felt the valuation of its shares had become sufficiently attractive and initiated a position.
Another new holding added during the fourth quarter was Czech Republic-based Komercni Banca. This bank is well run with a strong capital base, high dividend yield and a low loan to deposit ratio. Its long track record is evidence of a cautious approach and it now appears well positioned to benefit from a pick-up in investment across the country.
While we invest from a bottom-up perspective rather than making sector calls, banking is a sector notable for the opportunities currently on offer. The caveat here, however, is that these opportunities need to be approached with a focus on quality and the investments made with a long-term horizon in mind.