Why foreigners love SA financial stocks
Amid the rampant negativity that many South Africans exhibit towards the state of the country, our financial markets continue to rise to new record levels. The marginal buyer, pushing up SA stocks, especially financial and industrial stocks is more often than not emerging market fund managers, i.e. foreigners. Why is it that these investors are so positive about SA stocks when so many South Africans are negative about the country?
During my 14 years as a stock broking analyst, focusing on financial stocks, I spent a great deal of my time dealing with emerging market (EM) fund managers and as a result, I have a very good idea of what makes them tick. As with all investment decisions, there is always a trade-off between risk and reward. In the case of SA financial stocks, EM investors consider them low risk (much lower risk than what they can find in Russia, Turkey and other emerging markets), offering moderate returns but with a possible kicker from African growth opportunities. EM fund managers are less fond of SA resource stocks because of the risk of labour unrest, falling commodity prices and further black economic empowerment (BEE) dilution.
Over the past 5 years, the JSE All Share Index has risen by 75% in rand terms and 16% in dollar terms. This compares very favourably with the MSCI Emerging Market index that declined by 6% over the same period. Specifically, the Russian MICEX index fell by almost half in dollar terms in the period, while the MSCI Turkey index fell by 2%. If we consider general retailers (like Shoprite and Pick ‘n Pay), Banks (like Standard Bank and FirstRand) and life assurers (like Old Mutual and Sanlam), the outperformance is even more extreme. In dollar terms, these indices went up 39%, 19% and 34% respectively over the 5-year period.
If we drill down further, at current levels, investors are willing to pay much more for SA banks than there other EM counterparts. A globally acceptable metric for measuring the valuations of banks is to look at their market capitalisation (what investors are willing to pay for the entire company) divided by their levels of capital (excess of assets over liabilities), also known as their book value. The metric used is also called price to book or P/B.
At current levels, SA banks trade on an average P/B (based on the latest disclosed book values) of 2.3 times. The higher this multiple is, the more valuable a bank stock or index is. The 2.3X multiple for SA banks compares to an average multiple for all global emerging markets of 1.8X, which makes the SA banks 27% more valuable. Compared with Turkish banks, the SA banks are 60% more valuable, while they are more than twice as valuable as Nigerian banks and 3 times more valuable than Russian banks. The premium to developed market banks (still recovering from the global credit crisis) is even more extreme with most American, UK and European banks trading at large discounts to book. It is clear from these comparisons that foreigners love SA financial stocks relative to other options. The question is why? Let’s now look at the risk and growth considerations that help investors arrive at this point of view.
The main reasons why SA financial companies are considered lower risk than other EM financial companies by EM investors are: 1) solid balance sheets post the global credit crisis; 2) strong management teams; 3) excellent corporate governance; 4) world-leading auditing and accounting standards; 5) a highly regulated equity market; 6) low BEE risk and 7) low labour and electricity risk.
Post the 2008 global financial crisis, developed market banks and insurers lost a great deal of value because of the toxic assets on their balance sheets, pressure on their capital levels and an increase in the perceived risk associated with them. Unlike the developed market financial companies and some of emerging market financial companies, SA banks and life assurers had very little exposure to these toxic assets and emerged from the crisis with very strong balance sheets. This meant a very low risk of failure or having to raise additional capital. The only exception to this trend over the past 5 years has been the failure of African Bank, but this was due a set of circumstances unique to that company. The rest of the SA financial sector remains in very healthy shape and investors recognise this strong position.
The SA banking and life assurance industry attracts high quality people and have very strong, proven management teams. Management teams are open and available to their investors and provide detailed and clear information about their companies that investors can use to make decisions. Investors are highly appreciative of SA management quality and openness.
The financial sector in SA has been very diligent in adopting the highest corporate governance standards in the world, including King III which sets clear guidelines on the way in which company boards should be constituted and should operate. This increases the faith of investors that company boards will protect their interest.
SA ranks tops according to the World Economic Forum when it comes to auditing and accounting standards and have done so for 3 years running. SA has been an early adopter of the International Financial Reporting Standards (IFRS), which is still being introduced in other countries world-wide. Because of these high standards, investors are very comfortable with the information that is disclosed by SA financial companies. They can believe in the truthfulness of the information that is disclosed.
The JSE is a highly regulated equity market that ensures protection for investors that buy and sell shares on the platform. Investors can be confident that when they pay for shares, they will receive the shares and when they sell them, they will receive the money (high settlement standards). Investors also feel comfortable that the playing field in SA is level and that they do not have to compete with insiders that have more information than they do (insider trading regulations).
The SA financial sector has been extremely successful in implementing black economic empowerment (BEE) with almost all large companies recording a BEE score of 85 and above out of a possible 100. All companies have successfully increased BEE ownership; increased employment equity at management level and in general; improved skills development, procurement and empowerment financing; done a great deal to improve enterprise development and socio economic development; and increased access to financial services. As a result, there is reduced risk to investors that their future returns may be diluted by more onerous BEE requirements.
Finally, the financial sector in SA has not been negatively impacted by labour unrest, while any risk due to load shedding is limited for this sector of the economy. These risks are more prevalent for the resources sector in SA, including platinum and gold mines.
EM investors have an appetite for investing in countries where they can expect healthy returns. The returns that investors can expect from a sector such as the financial sector, is a product of the prospects of the country as a whole (economic growth) and the prospects of the industry that the sector operates in. Although the SA economy does not have the same growth prospects as many other emerging markets (like China and countries in Africa), it has superior growth prospects to most of the developed world and has more stable growth prospects than many other emerging markets (e.g. Russia and Turkey).
The financial sector in SA generally has higher growth potential than the country as a whole. The main reason for this is that SA financial companies are increasingly investing and generating strong growth from other African countries and other emerging markets. EM fund managers are looking at Africa with fresh eyes and see meaningful potential for the continent to become the next global growth area. As it stands, sub-Sahara African countries have delivered superior growth rates over the past decade and are expected to continue delivering this, helped by increasing foreign investment (including from SA companies) and a rapidly developing retail market.
Although EM investors can invest directly in African stocks, they are often limited by the liquidity in local equity markets and by the perceived risks in these companies. Many investors therefore opt to gain their African exposure through SA companies that are traded on a very liquid JSE and are well run and highly regulated.
What could change the positive situation?
Although the perception of the SA financial sector in the eyes of foreign investors is very positive at the moment, there are potential developments that could change this view. The main one of these is potential downgrades to SA’s sovereign credit rating. At the moment SA has a stable credit rating with two of the rating agencies having a stable outlook and one having a negative outlook, driven by a weaker economic growth outlook, labour concerns and concerns over electricity supply. If the SA economic situation declines further going forward, it is possible that credit downgrades may occur over the next few years, which may make SA a less attractive investment destination.
Another development that could reduce the attraction of SA financial stocks is a continued weakening of the rand, which erodes dollar returns for investors. Over the past year the rand has lost 7% against the dollar. The SA currency is arguably undervalued at current levels and could see a recovery in 2015.
A reduction in growth prospects of SA financial companies may also impact the positive view that investors currently have of the sector. This would occur if the SA economy deteriorates further or if African growth starts to taper off. In the current environment, low oil prices could have a negative impact on exports from African countries such as Nigeria. However, lower petrol prices should offer a boost to the SA and other African economies. SA interest rates are currently in a rising cycle, which could put pressure on the economy. However, the lower petrol prices could result in lower inflation, which could delay further interest rate hikes, therefore limiting the economic impact.
Finally, negative developments on the corporate governance, regulatory or management front could also change views negatively, although this does not appear to be on the cards at the moment.
South Africans should be very proud of our private sector and of our financial sector in particular. We should take note of the positive view that foreigners have of our private sector and realise that everything is not doom and gloom. I often hear negative views being expressed about sub-Saharan Africa, but what readers should start to accept is that the future of this region is looking very positive and this is increasingly being recognised by foreigners. Our SA companies are very well positioned to take advantage of this trend.
At the same time, we should protect what we have here in SA. We must protect our high professional standards, our regulations, our rule of law, etc. We must not allow for these assets to decline in value going forward.
Furthermore, we must address the issues where we are struggling. We need to address the current electricity concerns, we need to successfully deal with our education, we need to address corruption concerns and most importantly, we need to reduce unemployment. If these issues can be dealt with, our private sector could perform even more strongly and attract even more foreign investment. In addition, if we can address labour unrest in the resource sector and reduce BEE uncertainty, this sector could also attract more interest from investors over the long-term (in the short-term, falling commodity prices are likely to dominate).
What do you think of our private sector and our financial companies in particular? Do you see the potential in Africa? Do you think we can address our problems and improve our outlook? Please let me know what you think.
In the mean time, keep your talk straight!