ASSESSING BANK QUALITY IN A COMPLICATED COVID-19 ENVIRONMENT

Local banking stocks have been under pressure for a number of years, and the arrival of Covid-19 wrought destruction on share prices. Analysts share their insights about the investment outlook for this sector, which will be heavily burdened by the economic consequences of the pandemic.

By Brendan Peacock

Though there are 19 locally registered banks doing business in South Africa, the banking sector continues to be dominated by five players, which together hold the majority of all assets in the sector. Any retail investor looking to pick a performer among local banks will almost certainly be weighing up their options from the big five.

The banking sector has been under significant pressure for years, with expectations of economic recovery in SA continually deferred. In the second half of 2019, PwC, in its Major Banks Analysis report, said banks are sensitive to stresses in the domestic economy and the broader global economic context. Lacklustre growth meant heightened credit risk and subdued economic activity across all customer segments, which contributed to earnings pressure, the report said. And that was before Covid-19 and lockdown laid waste to remaining economic activity.

According to the South African Reserve Bank’s (SARB’s) sector trends report from February, shortly before Covid-19 entered our consciousness, the sector controlled just more than R6tr in assets, 9.7% up on the prior year, with R4.4tr in gross loans and advances, R1tr in home loans and R986bn in term loans.

Sector returns on equity were down from 15.9% to 14.3%, return on assets was down from 1.29% to 1.14% and the sector’s cost-to-income ratio had slid from 57.3% to 58.6%. Capital adequacy had also declined from 16.3% on average to 16.2%.

Covid-19 wrought destruction on banking shares as investors weighed up the prospects of loan books turning bad, transactional activity grinding to a halt and the large-scale liquidation of investments to obtain much-needed cash.

It is a bleak picture. Going by order of market capitalisation, FirstRand has shed 37.7% of its share price in 2020 to R221bn at a price-to-earnings ratio (P/E) of 7.7 times. Standard Bank has lost 44.8% of its value to R150bn and is trading at a P/E of 5.2. Capitec, now worth R108bn, has lost 35.6%, though its P/E remains a sturdy and demanding 17. Absa is down to R67bn, having shed 67% of its value since the beginning of the year and is at a P/E of 4.5. Nedbank brings up the rear after losing 67% to be worth R43bn at a lowly P/E of 3.3.

Some investors may take a look at the “cheap” valuations on offer in the sector but may be wary of how to sort the wheat from the chaff in an environment where seemingly every company has shed value in irrational sell-offs.

Chris Steward Portfolio manager at Ninety One

Chris Steward, portfolio manager at Ninety One (previously Investec Asset Management), says a great deal of action in a very short time has changed the investment landscape materially. “Most banks reporting recently had recorded small single-digit earnings increments downwards or upwards for the last year, with Nedbank the weakest and FirstRand the strongest. But the global economy was looking reasonably supportive.

“When stocks are sold off as aggressively as during March, relative performance becomes less pronounced because it looks like they have all been annihilated. Some may have outperformed, but it’s less noticeable,” he says.

Before Covid-19 a quality bias in pricing was emerging, Steward says. “Banks with stronger capitalisation, better organic earnings generation, better performance track records of capital allocation and management delivery, like FirstRand, Capitec and to a lesser degree Standard Bank, were separated from the bottom performers by a good 20%.”

According to Steward, cuts in interest rates – already greater by April than expected for the whole of 2020 – are generally negative for bank earnings, since free capital plus interest-free deposits are reinvested at lower rates. “In a traditional cycle banks get compensation from an uptick in credit as consumers and corporates take advantage of cheaper borrowing. But the usual credit quality improvement associated with lower rates will not eventuate in the wake of Covid-19.”

With Mastercard reporting that transactional activity in SA has effectively fallen off a cliff during lockdown, banks lose out on their bread-and-butter earnings. No ATM withdrawals, no point-of-sale transactions, no corporate advisory work. The only upside is increased trading activity that brings fees. “There is the potential for an unprecedented uptick in non-performing loans and impairments, even superseding what we saw in the 2008 global financial crash. Bank earnings could fall by 40% year-on-year,” says Steward.

Essentially, Covid-19 doesn’t change the picture of quality in the sector, Steward adds. “The less well-positioned franchises like Absa and Nedbank have arguably less capital, generate lower returns on equity, and can generate less organic capital.”

What has confused the investment outlook has been the Prudential Authority’s (PA’s) interventions to ensure liquidity and capital adequacy in the sector. “During a crash like this investors start withdrawing from funds, fund managers have to liquidate assets to give cash to investors, and typically government securities are sold off. Banks have to make a market, but then need to shore up their own liquidity. The first thing the PA did was to reduce Basel regulations from 100% to 80% to give banks the liquidity headroom to meet extraordinary demands for cash.

“Then the SARB went to market to buy government securities, which was portrayed less as quantitative easing and more as simply restoring functionality to the bond market. The second step taken by the authorities was to recognise the extraordinary demand for credit in a lockdown affected economy. But banks worry about their books and the ability of borrowers to service their debts, so the PA announced that banks could eat into regulatory buffers to keep lending,” he explains.

Finally, the third important step was to allow banks to deal with an expected spike in non-performing loans. “A flood of loans could move from fully performing to stage 2 and even to stage 3, which is non-performing. When that happens and customers are recognised as being in distress, typically banks run into IFRS [international financial reporting standards] accounting issues that would cause their capital provisioning requirements to shoot up. Covid-19 has led to payment holidays or incremental liquidity for borrowers, to change contractual terms of loans and avoid accounting difficulties,” Steward says.

The obvious danger is that banks will have a hard time telling the genuine cases of Covid-19 hard-luck cases from customers who have less legitimate claims.

The obvious danger is that banks will have a hard time telling the genuine cases of Covid-19 hard-luck cases from customers who have less legitimate claims. Each bank’s loan book has millions of customers. “I know which route I’d prefer as a shareholder and which is more practical, and they aren’t the same,” says Steward.

The PA also initially announced that banks should pay no dividends, and then changed their minds. FirstRand had already paid its dividend, but subsequently Capitec elected to hold onto its payout as it eyed a tough and uncertain 2020.

The problem with these interventions, from an investor’s point of view, is that the regulator cannot discriminate between banks. According to Steward, this is the same globally. “Thinly-capitalised and wellcapitalised banks alike are told not to pay dividends. It’s a false hobbling of the best runners in the race and generally we’ve been prepared to pay a premium for banks with better balance sheets, higher ROE [return-on-equity], and long-term capital allocation records. If you run a bank well and generate organic capital and can still pay a dividend, you’re hamstrung because other banks can’t. Any discrimination between banks by the regulator may lead to fears about some banks’ business models and a run on those banks by depositors.”

Kokkie Kooyman Portfolio manager at Denker Capital

Kokkie Kooyman and Jan Meintjies, portfolio managers at Denker Capital, agree that the more diversified banks and high-quality operations will be best placed to deal with non-performing loans.

“The banks with the lowest cost-to-income ratios and highest capital ratios will be best placed, though I’d say all our banks are in good shape and have been cautious growing their books. Consumer loans like credit cards and personal loans will see the highest percentage of bad debts. The segment showing the highest growth rate over the last 12 months has been personal loans, and this is where the pain will come from. A lot depends on how quickly lockdown ends and, for example, when tourists start coming back,” says Kooyman.

In order to boost liquidity in the economy, the government announced a R200bn loan guarantee scheme, supported by the SARB, to entice banks to continue lending amid the lockdown.

As for corporate banking, Kooyman says he has no reason to believe any corporates may fall over as a result of Covid-19, with the exception of Edcon. “But there will be pain. Retailers who have sold on credit will suffer.”

Zaid Paruk Portfolio manager at Aeon Investment Management

Zaid Paruk, portfolio manager at Aeon Investment Management, expects a risk-off mentality to persist after Covid-19 has passed. “We have seen a sharp rise in unsecured lending in the recent past. Of the traditional banks, excluding Capitec, the impairment provision as a percentage of the gross loan book is the most conservative at FirstRand, at 4.4%, with Nedbank the least conservative at 2.3%. Due to lower interest rates, all banks will see income dropping going forward on lower net interest margins. Some banks are more exposed to certain economic sectors than others, which means Covid-19 will have different consequences for different banks, but information is still limited at this point and will only come to light once transparency on non-performing loans starts to flow into the market.”

Paruk says local banks with offshore operations, such as Investec, may not necessarily have an advantage. “Almost half of Investec’s loan book consists of mortgages and commercial property advances. In an environment with valuations under pressure, we expect to see lower activity levels as property owners are ‘nursed’ back to good health.”

Kooyman agrees that while it depends on the particular footprint of the banks, certain local banks have been operating in other territories for a long time. “I don’t foresee a problem. Having said that, oil-producing countries like Nigeria and Angola are already battling and both Zambia and Zimbabwe are struggling, so exposure there right now is a negative. The general rule is that if you can be on the front foot, this is an excellent time to take market share and buy competitors who struggle.” ■

Picking a winner

Experts weigh in on the outlook for local banking shares.

Ninety One’s Chris Steward says he has a bias towards good balance sheets. “Capital adequacy would generally steer me towards FirstRand and Capitec. Between those two I would prefer more diversification and select FirstRand as a consequence. Banking is a tough place to be and although valuations are attractive, I wouldn’t charge in just yet. Absa and Nedbank are trading on very low P/Es, but that’s based on historic revenue. On a forwardearnings basis the picture would be different.”

Aeon Investment Management’s Zaid Paruk says despite depressed valuations he would also remain cautious in calling a turning point in light of a poor fundamental economic outlook. “We believe earnings diversification is most important and Standard Bank is our preference in the sector. We will be adding to our current underweight position as the valuation and fundamentals improve.” Denker Capital’s Kokkie Kooyman and Jan Meintjies have

slightly differing views on sector winners. Kooyman selects Standard Bank and FirstRand as best-placed. “Capitec is, in theory, most at risk due to where it lends, but we’ll see how good their credit scoring was, but given valuations this is an excellent time to be picking up Capitec and FirstRand, depending on your investment time horizon. If your time horizon is shorter, Absa and Nedbank should bounce back hardest when the market bottoms. “In general, however, it’s a dangerous time to pick individual stocks because you won’t know which bank has unexpectedly large exposure. The whole sector has been sold down so I would rather just get the diversification offered by a good financials fund,” he says.

Meintjies points out that Capitec’s total credit book is protected from retrenchments and liquidations through thirdparty insurance and does not have the same corporate exposures as its competitors. “They may have the riskier book as far as retail banking goes, but I think they are better-placed compared with other banks.” ■

Digital banks and the new normal

Will digital retail banking continue cashing in post-lockdown?

Retailers, telecoms operators, fintech start-ups and fully digital banks are all vying to take a slice of the banking pie, whether through mobile payments, lending, deposits or asset management. Traditional banks are coming under additional pressure to provide more flexible digital channels and bank account value to defend market share.

Discovery and TymeBank launched fully digital banking offerings in 2019, with TymeBank already having more than 1m account holders, though fewer than half have been transacting regularly. With the world realising the ability to work remotely thanks to lockdown restrictions, how long before that translates into a headlong shift to digital retail banking?

“The good thing for Discovery and TymeBank is that neither will have a big lending book up and running yet,” says Ninety One’s Chris Steward. “It may be that digital banks can use recent events to push people towards digital banking, but in general the environment remains a difficult sell for them. Neither has yet made enough of an impact to affect the prospects of the big five yet.”

Aeon’s Zaid Paruk says digital upstarts have the capability to operate at a lower cost model because they have no legacy systems in place.

“Distribution channels are fundamental in their expansion, and the partnership between Pick n Pay and TymeBank has been successful due to the specific focus. Discovery has had some challenges in starting up, but the bank’s products are cross-sold with other Discovery products, so it has been expanding its market share off a low base. A branchless, online-only model should be least affected by Covid-19 at this stage, with a small advances book and better credit-quality customer,” says Paruk.

Denker Capital’s Kokkie Kooyman says credit quality will be an important issue, since banks looking to gain market share almost always pick up the highest percentage of bad debts. “TymeBank can thank its lucky stars it hasn’t been able to launch a credit card offering yet. I think Discovery may battle in that potential clients could be reluctant to move while income is uncertain, but if their digital offering is good, I expect they will be back. The drawback is that the lockdown gives the other banks a good three months to progress their own digital offerings.” ■

editorial@finweek.co.za