South African Banks are not expected to produce strong earnings over the next 12 months. Consensus estimates – compiled by a matrix of fact-finding analysts – have growth falling on a single digit spectrum for each of the big four banks. The market, however, thinks they’ll be significantly worse and has priced them as such.
The chart headlining this note plots the real dividends of the SA banking index in red, and its relative performance against cash, in blue. It is generally accepted that prevailing share prices tend to incorporate future earnings (and dividend) expectations. We have therefore shifted the relative performance line (blue) forward by 12 months.
This adjustment improves the correlation between the two line graphs, and, importantly, gives us an indication of where the market thinks SA bank dividends are headed.
During the financial crisis of 2008/09 the SA banking index saw its dividends paid to investors contract by 25%. Cash subsequently outperformed banks on a relative basis to the tune of 50%, the crumpling bank PE ratios magnifying the loss in earnings. The market correctly predicted the fall in dividends, the blue line turning down before the red line followed suit. Remember the blue line has been shifted forward.
Today, the market is making another macabre prediction. At the time of writing the SA banking index has underperformed cash by 17% since July 2015. If the relationship illustrated above holds, SA banks need to slash their dividends 6-12 months from now. Graphically, this will see the red line track the blue line lower.
Banks face a completely different set of risks compared to those prevalent during the financial crisis. And more onerous regulation has curbed the risky lending that caused much of the pain in 2008/09. If they can spite the market and eek out the earnings that analysts are predicting then suddenly the dividend yields that SA banks are offering look golden.
There are reasons though, not to get ahead of oneself. Because corporates (including banks) cannot hold higher credit ratings than the country in which they are domiciled, a downgrade of our sovereign credit rating to junk status will force our corporates one notch lower on the ratings ladder.
This, along with rising domestic interest rates, will increase their cost of borrowing. Passing this cost on to their already over-indebted customers – through higher lending rates – will be difficult without agitating a material amount of debt teetering on turning bad. Even without the downgrade, the unsavoury trajectory of the SA economy, combined with the growth quashing rise in interest rates, is likely to facilitate a rise in bad debts.
Flipping the coin to its optimistic side, higher interest rates mean that banks earn more on the funds they lend out through what is known as the endowment effect. The post-crisis increase in banking regulation has also forced a more conservative approach to said lending, and under similar stresses to those experienced in 2008/09, fewer customers are expected to skirt their debt obligations.
Fixing another feather in their cap, SA banks have lead the global implementation of the Basel III regulations. This should give investors some comfort that SA banks are at the forefront of prudent risk management practices.
In terms of growing their loan books – and therefore the amount of interest they earn – certain SA banks have established the necessary footprint in Africa and may yet benefit from its industrialisation and urbanisation. This is especially true in those countries not held hostage by mercilessly aloof commodity prices.
Combining these dynamics to gauge the effect on SA bank earnings (and dividends!) requires a lot of analytical finessing without perfect information. But perhaps the opportunity here, given the magnitude of the implied earnings and dividend contraction, demands a more qualitative, rather than quantitative approach. In this vain it is intriguing to note that banks have, for a number of years, been subject to diminishing favour among investors, the latter smitten with acquisition happy retailers and high yielding property plays.
There are legitimate reasons for the growing aversion toward banks. The shift to a lower earnings profile, predominantly facilitated by suffocating regulatory changes, is more structural than cyclical. This deters long-term investors. But perhaps the latest de-rating has taken the bashing one step too far. And herein lays the crux of the matter. An investment can be successful, albeit in the short-term, without earnings growth, when cheap enough.
A particularly jarring anecdote follows that pinpoints the acute abhorrence of investors toward SA banks in particular. For the last 8 years, Standard Bank has grown its dividend paid to investors by roughly 9% per annum. Economic theory propounds that these above-inflation returns be rewarded through price appreciation. However, such has been the voracity of the recent selloff in these financial counters that Standard Bank’s share price is now close to where it was in 2007 – very little price appreciation then. It arguably renders the likes of Standard Bank very cheap.
Perception has punished the ratings of SA bank; a devilish downgrade is coming; political meddling is morphing into political mayhem; consumers are careening toward debt counselling; debt burdened businesses are flirting with bankruptcy; encroaching, margin munching regulation is being forced; and a glut of global aversion to the industry are all weighing on SA banks, possibly to the verbose extent to which the alliteration of adjectives suggest.
If these perceptions change, earnings won’t matter. Yield seeking investors – and there are plenty in a world of negative interest rates – will climb into the shares when they realise that the punchy dividends are sustainable, that earnings aren’t going to plunge, that things aren’t as bad as they originally thought. And maybe the investment case for SA banks rests on the seemingly porous fact that, in the end, things are seldom as bad as they seem.