South African investors have had a challenging time in financial markets, largely due to lacklustre returns from local equities. This is at a time when global equities have done well, and post-apartheid South Africa is going through possibly one of the most challenging times from a political and economic standpoint. The news flow has been dominated by a barrage of negative news for South Africa on one hand and catchy headlines of ‘’roaring” US equity markets on the other. It therefore comes as no surprise that local investors are questioning whether they should remain invested in underperforming local equities or jump on the offshore bandwagon.
Valuation driven investing
Valuation driven investing is somewhat counter-intuitive, advocating that you buy undervalued assets and avoid overvalued assets. The approach boils down to determining what an investment is worth and getting it at a discounted price. This often means buying assets that have underperformed and avoiding those that have done well. In the context of South African investors, this would imply avoiding the richly valued global technology stocks and buying the unloved and cheap local equities. Whilst the latter decision is likely to be the least comfortable in the short term, it will likely serve investors well in the longer term, as it also comes with a lower probability of capital loss given the current margin of safety on offer.
Investing is a challenging pursuit that is fraught with market noise that will continuously test our patience, emotions and overall decision-making capabilities. It is, therefore, imperative that investors adopt a robust framework for critically processing information with the aim of separating useful information from market noise in constructing a credible and falsifiable investment thesis.
The case for South African financials
A good case in point would be South African financials, an attractive part of the local equity market from a valuation standpoint. This sector is dominated by South African banks, which are heavily geared to the South African economy. The banks can provide useful insights on how domestic facing companies can deliver exceptional returns in a struggling economy when bought at the right price.
This sector sold-off aggressively in the wake of the Covid-19 outbreak, as investors fretted over potential increases in loan losses, as well as the inability of banks to grow earnings in a low to no growth environment. The market is in essence extrapolating the current tough economic environment in South Africa into the future.
Fundamentals versus valuations
As always, the investor’s role is to ascertain whether valuations are reflective of fundamentals and if it is right to assume that the status quo will continue. In this case, one must decide whether the market is correct in implying that banks will face large loan losses and will need to embark on potentially dilutive capital raises. To get a better feel of this, it’s worth considering the capital levels of South African banks and the quality of their loan books.
South African banks are well capitalized as evidenced by the regulatory rollback we have seen since the start of the Covid-19 pandemic. Domestic credit extension has also been constrained heading into the crisis, with most banking books exposed to higher-quality borrowers at reasonable loan-to-value ratios. In other words, South African banks have been very prudent about who they have lent money to over the past few years and have been incredibly well managed and therefore entered this crisis on a much stronger footing. This should provide a reasonable degree of comfort for investors.
We also acknowledge short-term headwinds such as the interest rate cycle and its impact on banking earnings. The recent cuts in interest rates will negatively impact the bottom line of South African banks in the short term due to the negative endowment effect. However, this is not a terrible entry point for counter-cyclical investors. It might be close to impossible to accurately point out when interest rates will turn, but one would expect banking profitability to improve once this happens, which could potentially be a catalyst for a re-rating of the sector.
Further to this is the thematic issue of the non-payment of dividends by banks that has spooked investors. One must remember that this serves to protect shareholder capital and has been done with the aim of avoiding potentially dilutive capital raises or government bailouts. Investors need not worry as long as banks use this to bolster their capital positions and avoid extending unprofitable loans.
We also find comfort in the ability of South African banks to generate returns on equity that are well in excess of their costs of equity, a key ingredient in generating profits and regulatory capital.
The big question for the investor then becomes, what does this all mean in terms of expected returns?
Our modelling assumptions are based on very conservative growth expectations to account for the challenging domestic macro environment and suggest a significant capital return from re-rating in the long term, together with an attractive yield. Indeed, the yield is unlikely to be realised this year (largely due to the SARB’s request to local banks to halt dividend payments in order to bolster balance sheets further). We account for this by assuming non-payment of dividends in 2020 and 2021 in our modelling and still arrive at compelling valuations given current market prices. We again reiterate that a non-payment of dividends is not always a bad thing, especially if the capital is not misallocated.
Identifying opportunities is one aspect of investing and having the character to implement them is another, especially when one expects a lot of noise in the short term. At Morningstar, we invest for the long term and as such are comfortable with sitting through the noise and expressing our views in a diversified manner that we believe will help our clients achieve their financial goals in the medium to long term. As a result, we have a healthy exposure to local banks in our domestic portfolios, which we believe will serve investors well.
By: Simbarashe Mangwiro, Associate Investment Analyst, Morningstar Investment Management South Africa