Looking for Value in Emerging Market Banks
Published May 30, 2021
A great myth in investing has been the homogeneity of Emerging Markets. Once you leave North America, Western Europe, and Japan, it’s like the world is all the same. Whether it’s Emerging Market banks, oil companies, or grocery stores, nuances are irrelevant.
Yes, most Emerging Markets require outside capital, and the institutions required for stable markets may not be well established. The value of the dollar and US interest rates are critical in these markets, but they are for other asset classes, too.
Emerging Markets usually lie on the margin of capital markets, which makes things volatile. This is neither categorically good nor bad. As I have tried to show throughout this blog, peeling back a few layers can uncover some wonderful ideas despite market or country shortcomings.
I want to walk through Emerging Market banks today because it offers a nice contrast to the European financials piece last month. While exposed to different risks than their European peers, many Emerging Market financials can offer higher growth, better margins, and simpler business models than their developed counterparts.
In many cases, and unlike in the past, financials are not the largest weighting in the index. Therefore, they are relatively unloved by the very investors that treat Emerging Markets as a single category. In many markets, other sectors took that mantle over a decade ago.
First, we will cover the pros and cons of investing in Emerging Market (EM) banks. After that, I will highlight a few markets that I am avoiding. Then, I will mention a couple of ideas on my radar.
The Pros and Cons of Emerging Market Banks
Investing in EM banks requires an augmented skillset to investing in US or European banks. There are macro, regulatory, and political considerations that have a greater impact on the sector in any given country. This can be both a blessing and a curse.
Credit Growth Can Be Much Faster
Most EM banks have a longer runway to grow credit vs. developed market peers. There are two general factors behind this, credit to GDP and GDP growth. The lower the former and the faster the latter, the more room banks generally have to grow loans. The chart below illustrates the general correlation between GDP per capita and credit penetration.
Interest Rates are Nearly Always Higher and Yield Curves Steeper
A lot of things go into interest rate pricing, and the inputs vary dynamically in importance. Inflation, policy credibility, and capital flows are just a few factors. In EM, inflation is generally higher, policy credibility has historically been lower, and capital has been more volatile. In addition, uncertainty typically compounds with time, suggesting that the distant future is more uncertain than the next week. These arguments point to higher interest rates over time and a steeper yield curve.
A steeper yield curve makes a bank’s bread and butter of maturity transformation more profitable—low-cost deposits fund higher-yielding loans with greater maturity.
The Industry is Typically Concentrated
There are usually three or four big banks that control the market in many emerging markets, sometimes fewer. This limited competition mitigates pricing and cost pressures. It is tough to dislodge the incumbents, and it keeps the field stable.
Banking is also inherently capital intensive and has become more so with the regulatory measures implemented since the GFC. Banks have to hold more capital against loans and invest more in technology to remain competitive. All across the globe, this means bigger barriers to new entrants.
Capital is Scarce
Investors are always trading to find the best return for their money, but natural barriers keep money out of EMs relative to Developed Markets. Some of the pros already discussed keep out a lot of incremental capital. Also, in many EMs, a large developed market bank might be too large for an investment in an EM bank to move the needle.
Some other investors might not be comfortable with the risk even if it comes with a higher expected return. The cons we’ll discuss below add uncertainty which reduces capital inflows and allows market inefficiencies to persist for those able to take advantage of them.
Stability of Capital Flows
This should be self-explanatory. The more capital sloshing around in a system, the lower the incremental returns and the more dependent the system becomes on access to capital to maintain returns. It is that classic transition from paying off debt comfortably with cash flows to not worrying about ever paying it back because you can refinance.
If there’s an abrupt withdrawal of that capital, bad things happen. Just look at the Paso, first-round presidential elections in Argentina in 2019 or Lava Jato in Brazil in 2014. These situations only surfaced because a large influx of capital came into markets in the preceding years and then was cut off abruptly, exposing the fragilities.
A lot of EM investing is about riding a rising tide of capital or finding more tranquil markets where valuation alone can take care of returns. Not all countries are as vulnerable nor markets equally valued, which creates opportunities.
Foreign Exchange is embedded in various ways into EM bank analysis. Depositors may not trust the local currency, so they keep many deposits in USD or EUR. Borrowers may have no exports for foreign exchange earnings but seek USD or EUR loans because they are lower cost. The authorities may have a foreign exchange rate policy to keep rates within a certain level that encourages certain behaviors.
The Eastern European mortgage crisis, Turkey in the last few years, the Asian financial crisis of the late ‘90s, and the Argentina 2001 default all show what can happen with these risks.
Over the last couple of decades, monetary policy has largely centered around inflation targeting. In most EMs, this has meant adjusting monetary policy to keep inflation around a specific level or within a band. Is inflation too high? Raise interest rates and vice versa.
When this orthodoxy is abandoned, panic usually follows. When Turkey fired the CB governor in March, the currency dropped 13%. Why? Because the incumbent had been pursuing traditional policy methods, and the Turkish president had stated that he is skeptical about the policy’s efficacy.
There is a perception that monetary policy in EMs is more political (in many cases, it is), so when there are changes, investors usually sell first and ask questions later.
This is also a function of weaker institutions, but EM countries are also subject to more regulatory volatility. Recently, the Nigerian central imposed a floor on loan to deposit ratios to encourage banks to lend even if the market did not demand it. Some countries require credit allocations to specific sectors, and others will tightly manage foreign exchange exposures.
Capital controls, which I’ve talked about before, also play a role in this risk.
None of this is inherently bad, but regulations can be out of step and have unintended consequences (along with opportunities). The risk is not being aware of the implications of rules and rule changes.
Emerging Market Banks I’m Avoiding
With the background in place, let’s delve into the details.
This list is illustrative and not exhaustive since there’s too much to cover in just one post. If you want my opinion on another market not listed here or in the next section, please reach out. Remember, this is only an opinion and NOT investment advice.
I am trying to avoid markets where long-term interest rates are likely to remain repressed, valuations are already relatively and absolutely extended, or there are systemic risks I am unwilling to take.
Eastern Europe, Especially EU Members
I covered this indirectly when I reviewed KBC Group (Brussels: KBC) in the second European Financials post. The trend is the same within many countries. Interest rates and margins in Eastern Europe are converging with the Euro rates, which has meant secular margin compression. Since most of these countries had small credit to GDP 20 years ago, margin loss has been more than made up for in volume as people buy cars, get mortgages, etc.
The last decade has seen a particular boom as many countries become the intermediate goods and services producers for their western neighbors, whether old fashion manufacturing, software development, call centers, and more. This transition has more room to run, but it is approaching its practical limits regarding relative wages and productivity.
This has led to lending markets where margins are down, growth is strong and provisioning is at or near historic lows.
For all that, you get low teens to high single-digit earnings yield before inflation at best. Furthermore, in markets like the Czech Republic and Hungary, banks trade at P/Bs greater than 1x. Investors are paying for future growth in markets where I think the trend is closer to the end than the beginning.
Finally, there is competition, both locally and domestically. While a few banks are dominant in each market, there are probably 6-8 players across all markets competing for growth. KBC, OTP, Raiffeisen, Erste, and Unicredit are all cross-border players in this space.
Brazil has always been a great market for banks. There are only a handful of domestic players with scale, interest rates are chronically high, and the yield curve has almost always been steep.
My issue with Brazilian banks is two-fold. First, you are getting a nominal low teens earnings yield for the main banks. After adjusting for inflation, you’re looking at high single digits. On a relative basis, this is not bad, but these are risks I am less comfortable taking.
Second, I believe inflation and interest rates in Brazil have been historically low for the last several years, long enough to possibly change behavioral and debt patterns. Rates have started to rise on the short end and it is too early to see how this plays out long term.
I mentioned financials briefly in my last post on Turkey. Because the Turkish financial system is highly dollarized and many corporates have borrowed in dollars, the system is unstable to shocks in the FX rate. We’ve seen a shoe drop already, and the system has had issues. I also believe there is a significant risk for more turbulence here in the form of capital controls or forced currency conversions (similar to the corralito in Argentina in 2002).
The above is enough for me to pass on Turkey at the moment.
EM Banks I Am Focusing on
These are some markets where I see current value or have on my radar for the future.
I won’t focus on Russia too long since I have highlighted it already in other posts (here and here). Sberbank (MICEX: SBER, LSE: SBER, OTC: SBRCY) is the dominant bank in the country and very well-run. Russia is also relatively starved for capital compared to similarly developed and sized economies. This allows Sberbank to earn particularly high margins while maintaining a low-cost base.
A bonus is the bank’s horizontal integration across many B2C and B2B businesses like cybersecurity, food delivery, and e-commerce. They don’t consume much capital in the scheme of things, but rather leverage the bank’s position in payments and customer information. They are lottery tickets with a better payout and lower cost than those you might find at your corner bodega or off-license.
The bank, along with Russia more broadly, has performed strongly on the back of higher commodity prices and the global recovery theme. As one of the largest banks in EM, Sberbank also has a fairly strong following in the analyst community. It never gets terribly cheap for these reasons, but it can trade close to book at certain points in the cycle. This is pretty good for a bank that generates ROE’s pretty consistently in the high teens.
However, the bank trades at closer to 1.4x P/B now, which puts the earnings yield in the mid-teens and likely high single digits after inflation, which is picking up in Russia. Rates have also been moving up as the Russian central bank, unlike most in the current world, raises rates to combat inflation. This means margins should come down as the curve continues to flatten.
It’s not that Sberbank cannot grow profits, but it will need to do so on volumes. We are at a point where we are losing a tailwind to profitability.
To sum it up, I like Sberbank and have been an owner for about 9 months now. At prices only 10-15% above current levels, I plan to trim my holdings in Sberbank to rotate into other assets in Russia or other banks in EMs. If you are a less active investor, you can also hold. In either case, be prepared to add back if there’s a sell-off and the bank trades back closer to book value.
The central Asian country of Georgia offers investors a pair of banks for consideration that compare favorably with other EM banks. I’ll give a brief overview of the country and then dive into the stocks.
Country and Economy Info
Georgia is a country of nearly 4 million people and an estimated GDP of $16 billion in 2020, according to the national statistics service, Geostat. Its economy is fairly diversified because they have to be. Like Turkey, its neighbor to the south, aside from location, Georgia has limited natural resources.
Georgia is at the nexus of the Caucasus region and serves as a critical junction for many of the world’s energy flows. Major oil and gas pipelines run through on their way to Turkey or to the country’s Black Sea ports. Unlike others, its environment allows it to derive most of its electricity from hydropower, which reduces its fuel imports more than comparable peers in the region.
On the economic end, Georgia has tried to differentiate itself from its former Soviet peers by being the most business-friendly. In its latest ease of doing business assessment in 2019, the World Bank ranked Georgia 7th in the world, between the US and UK, out of 190 countries.
Georgia is trying to be the services hub of the region and has done so by investing in tech, competitive tax regimes, and a business-friendly environment. Companies are easy to set up, rates are low, and they encourage the immigration of entrepreneurs through various incentives.
This relatively more services-friendly environment has also made Georgia a tourism destination for the region. It has mountains for skiing, the Black Sea for beach vacations, and a Mediterranean climate. Foreign tourism revenues accounted for 19% of the GDP in 2019 and are a major source of foreign exchange along with remittances which make up nearly 10% of GDP as well, according to the National Bank of Georgia.
Geopolitically, Georgia is probably the most westward looking of the central Asian former USSR republics. It has actively sought NATO membership and is the only country in the region with visa-free access to Europe.
Its relationship with Russia is correspondingly complicated. The 2008 war with Russia converted two of its northern regions into Russian satellites, and relations have never really normalized. Ironically, remittances from Georgians in Russia make up a sizable portion of the total.
Its relations with Turkey, Armenia, and Azerbaijan appear cordial (though I am no expert). The Azeris and the Turks need Georgia’s cooperation to transport energy from the Caspian to western markets, and there is not a lot to uncover.
Domestic politics look messy and likely are, although perhaps blown a bit out of proportion. The general election last year was contested by the runner-up party, and protests emerged. Europe and the US have closely watched the situation with tactical intervention by each. There is probably plenty to complain about with the governing party, but it is unclear whether protests truly prefer the alternative.
The three Georgian companies traded overseas certainly have taken the political flashpoints in stride. Politics add volatility, but the trend suggests it should be an opportunity rather than a risk.
The currency of Georgia is the Lari. Its chart is below. As you can see, over the last 5 years it looses about 9% per year.
This depreciation level is generally above inflation, which rarely has exceeded 6%, and short-term interest rates. This suggests that the Lari could be a relatively cheap currency, which could play into any local investment.
The country currently has FX reserves of ~$4 billion, which comfortably covers around 6 months of imports, the standard for FX reserve management. They have an adequate (though not overly large) level of foreign reserve.
As we’ll dive into below, Georgia is also a fairly dollarized economy, so it’ll be important to consider how the exchange rate moves.
The National Bank of Georgia adjusts monetary policy to achieve 3% inflation. It does this predominantly through the adjustment of short-term interest rates. Like most of the world, inflation has been picking up. The average 12-month inflation is 4.8%, so the NBG has raised interest rates, which currently stand at 9.5%.
Although not a direct monetary policy, the NBG also plays a critical role in the foreign exchange market and managing this risk within the financial system. The NBG has set prudent measures around foreign currency lending and borrowing by banks. It requires banks to set aside more capital against FX liabilities and de-dollarize retail lending through floors on foreign currency loans.
During COVID, the NBG also helped banks with liquidity by providing dollar swap lines to mitigate any loss in USD funding. The NBG looks to punch above its weight in terms of prudent regulation.
Georgia is a good market for its banks because it is concentrated, there is no surplus of capital, and the country can grow comfortably.
The two largest banks in Georgia have a combined market share of close to 80% in loans and deposits. Georgia is a small country, where aside from certain infrastructure projects, investment amounts are too small to move the needle for many large foreign investors or companies. Lastly, Georgia has room to grow. It has an acceptable level of debt to GDP (currently 61% as of 2020) and has come out of lockdowns later than many peers. This delay serves as a tailwind at this point.
I am looking at buying a combination of Bank of Georgia Group plc (LSE: BGEO) and TBC Bank Group plc (LSE: TBCG). I prefer Bank of Georgia, but the market is so small and these players are so relatively large that baring a huge error in management in one, the macro tide should lift all boats somewhat equally.
Both banks have traditionally generated 20+% ROEs. Adjusting for high single-digit inflation still gives a solid return in the teens. As noted above, this also jives with the gradual depreciation in the Lari over recent memory. Investors are compensated for the FX risk.
Their balance sheets are also pretty vanilla, with commercial lending and mortgages accounting for the bulk of the portfolio. Furthermore, most wholesale funding comes from DFIs at near concessional terms. With the COVID rebound ahead, both banks should see a boost in profitability and balance sheet growth in the coming quarters. We’ve already seen this in the 1Q numbers just released this month.
Lastly, both banks are ultimately controlled through UK holding companies. This, combined with being listed on the LSE, has led the banks to be lumped into the UK small-cap indices rather than a Frontier or EM index. The UK small caps like the UK market, in general, have been in post-Brexit doldrums, and any movement there in terms of inflows could provide a passive tailwind over the short run.
Regarding technicals, both banks had been in a downtrend since the beginning of the year. BGEO has broken through the trendline and resistance at the 1200p level. It looks a bit extended short-term, and I am looking to add on the next minor move down.
TBCG Is moving in the same direction but lagging a bit, and I will likewise be looking for a minor retrace for an entry.
The last market I wanted to focus on in this sample is Tanzania. This is not a market you can access through a normal brokerage account. You have to open an account locally, wire the funds internationally and, if you’re American, it comes with increased IRS reporting (this is NOT tax advice).
It’s not for the faint of heart, but there can be rewards. Here’s a quick summary. Go to the Global Value Hunter for a more detailed analysis of Tanzania and the opportunity set.
Country and Economy Info
Tanzania is a frontier market with a 2019 population of 58 million and a GDP of $63 billion according to the World Bank. It’s one of those economies that needs everything to grow, given its demographics and infrastructure.
The economy is broadly diversified and has many natural resources. Through further investment, it is also becoming a logistical hub for its land-locked neighbors to the west. For those looking for context, it is larger but less developed than its neighbor to the north, Kenya.
Its currency, the shilling, appears to have taken all of the pain of devaluation in one major move in 2015 and has been remarkably stable since. This is unusual for the region and Tanzania’s peers. Over the last 5 years, the average depreciation has been 1%.
While inflation is higher than 1%, it is still in the low single digits and short-term interest rates in the mid-single digits. These dynamics bode well for some stability.
Lastly, although there is a hefty spread to trade the currency, there are no capital controls, which is a decided benefit compared with, say, Nigeria.
The Bank of Tanzania currently targets 5% inflation over the medium term, so it is less constrained than Russia and Georgia to raise interest rates. It also means that unless inflation begins to flare up, short-term interest rates will remain lower and the yield curve steeper, which is a good thing for bank investors.
Like Georgia, Tanzania is a market where the aggregate fundamentals are so strong that you should do well by selecting one of the top players or, more simply, a basket of the top players.
First, the yield curve is monstrously steep, with material real yields across the curve. This is aided by the fact that only EAC citizens can own the bonds directly. NIMs are correspondingly fat—close to 10%—and most of the bad loans from the post-2015 contraction have been worked through.
A few large players also control the financial services market. The two largest banks have about half the loans and deposits. Outside investment in Tanzania has also largely been limited since the taper tantrum of 2015. FDI has dropped, and the stock market plunged as investors exited over the last five years. Capital is now scarce and rewarded.
As you can see below, the market has turned up in 2021 after consolidating for most of the last year.
Finally, there is growth. Tanzania has grown high single digits YoY over the past decade and is forecasted to continue to do so. Private credit is minimal, so the forecast is for sustainable credit growth over the short run.
Oddly a super short-term detractor, Tanzania never closed during COVID, and no nationwide lockdowns were imposed. The tourism sector suffered immensely, but local life carried on. While this reduces the short-term rate of change tailwinds, it also means that Tanzania has not needed to address many of the COVID legacy issues its neighbors are facing.
CRDB and NMB are the two largest and most actively traded banks in Tanzania. Both are plain vanilla businesses that focus on corporate and basic consumer lending. Both trades at sizable discounts to book (20%+) and offer 20+% ROE’s (mid 20s earnings yields at a minimum). NPL ratios are low single digits and both have large foreign shareholders. NMB has Arise, a consortium of the Norwegian government, Rabobank of the Netherlands, and the Dutch development bank FMO. CRDB has the Danish development agency, DANIDA.
Both also pay high single-digit dividend yields on 2020 profit based on share prices as of May 24th, 2021. In short, the banks trade like they are still in the midst of a crisis, but Tanzania has long turned the corner economically.
I do not include a commentary on technicals here because this is a much more illiquid market. Transaction costs are high, and trading in and out is expensive. Also, in NMB’s case, much of the market trades in blocks off-market, and no charts reflect this.
I am playing this by acquiring downsized position relative to more liquid markets and just holding for at least few years.
A key to investing is finding markets or sectors that have been capital constrained. Ideally, this is where assets are so cheaply valued that dividends, interest, or other cash flows alone provide attractive returns. All the better if there’s a catalyst that brings more capital and better valuations afterward.
I believe I have highlighted a few examples in EM banks where this might currently be the case. This is certainly not the entire opportunity set, since there may be other countries or banks in other markets that tick many of the boxes we’ve gone through here. This is a framework to look for opportunities now and in the future for financials.
The key is to be aware of the country’s cycle (financials outperform mid to late cycle), yield curve, competition, and unique macroeconomic environment.
Good luck out there!
The Castaway Capitalist
Disclaimer: No content on this website is intended to provide personal financial advice. This information is provided for information purposes only. We are publishers and not financial advisors. You should consider your personal situation, conduct your own analysis, and consult with a licensed professional advisor before making any investment decision. No content on the site constitutes – or should be construed as — a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented here, nor an offer of securities.
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