growth investors, we shy away from most cyclical stories while gravitating
toward structural ones. Inherently, banks are prone to credit cycles. However, with
a solid foundation in bottom-up analyses, the right banks can potentially provide
superlative and sustained performance over the long term.
Our investment in emerging market (EM) banks, through the Invesco Oppenheimer Developing Markets Fund, is guided by four core philosophies, which we discuss below.
1. Market structures matter enormously
A concentrated market structure may
give banks pricing power, allowing them to possibly generate consistent returns
above their cost of capital. Banking is an economy-of-scale business where the
largest lenders enjoy inherent advantages in low funding costs, better
risk-adjusted net interest margins (NIMs), and return on assets (ROAs). Figure 1.
Few banks in the world operate in such
attractive market structures as Russia and Peru, where the two countries leading
banks, Sberbank and Credicorp, respectively, control between 30% and 50% of the
deposits and assets in the banking system1.
With their extensive branch networks and entrenched brand awareness, these are
the go-to banks for customers’ deposits. This explains their competitive
risk-adjusted NIMs and their sustainable, superior ROAs of 2.0% to 2.5%2.
Figure 1: EM banks had materially higher ROAs
2. Long-term and durable growth may lay the foundation for multi-year compounding stories
It will surprise no one that banking
sectors in emerging markets have relatively low penetration rates that may
provide a runway for growth. However, we seek durable growth, meaning we look for banks that have the ammunition
to fund their asset expansion and those in geographies where there is a
second-order support for growth, typically from market share shifts.
A good illustration of this is the
Commercial International Bank Egypt (COMI), which operates in a country where
household and corporate debt were merely 7% and 27% of GDP3, respectively, as of August 2019. COMI’s
loan-to-deposit ratio was only 40.4% in Q3 20194,
meaning that more than half of COMI’s deposits were readily available to deploy
for future loan growth. Such excess deposit “ammunition” supports COMI’s
multi-year growth story.
Another great durable growth story is
Kotak Mahindra Bank (Kotak) in India, which has garnered growth from both
India’s increasing credit penetration as well as share gains from the
state-owned competitors. Figure 2. Kotak’s
underleveraged balance sheet (Tier 1 ratio of 18.7% in the second quarter of
fiscal year 2020, the highest among its peers5)
may allow it to fund its loan growth for several years to come.
Figure 2: Indian private banks have been outgrowing their public peers
Total credit in the Indian banking sector, excluding non-banking financial company (Trillion Indian Rupee)
3. Look for companies with massive optionality
We seek to own companies with massive
optionality that others ignore because it requires bold imagination and
patience. Digital banking is one such optionality. In recent years, many EM
banks have made significant digital investments to follow their digital-native
customers. This shift seems incremental at the get-go, but will likely bring
transformational results in the next few years. The potential result is cost
reduction, thanks to a smaller branch footprint, automated services, and
targeted customer acquisition.
The second result is the ability to cross-sell a whole host of financial products, including personal loans, wealth management, and insurance. The potential result is a boost in fee and investment income, which historically have been low for most EM banks. For banks like FirstRand in South Africa, whose retail unit (FNB) has migrated 71% of customers onto the digital channels in 20186, the upside from digital, particularly in reducing its high cost-to-asset ratio of 3.5%-4.0%, provided that optionality.
4. Own only best-in-class bank franchises
The key pillar for our approach to
investing in EM banks is to own only best-in-class bank franchises. The
hallmarks of these franchises are world-class management teams, the highest
standards of corporate governance, and durable competitive barriers (e.g., funding,
distribution, and brand).
In a typically 10x leverage business, errors
of commission prove far more expensive than errors of omission. Therefore, we
don’t concern ourselves with low-quality circumstances.
Valuation drivers for EM banks
While our core philosophies define our
investable universe, valuation dictates what eventually goes in or out of the
Our approach to valuation is centered on three
fundamental drivers of the banking business:
return on equity (ROE), cost of equity (COE), and growth. Figure 3.
Figure 3: Gordon Growth Valuation Model
These three drivers inform our views
on the long-term valuation metrics of a bank, including price-to- book, price-to-earnings
and dividend yield. We work relentlessly to achieve differentiated insights on
the three valuation drivers. Indeed, rather than employing a rigid formulaic
approach, it requires imagination to uncover where true value really lies.
Calculations of ROE are imprecise if you only extrapolate from the recent past,
or ignore the stage of the credit cycle an economy is in. COE assumptions are
prone to error without an inherent understanding of the macroeconomic context. We
believe that our decades of experience investing in emerging markets, coupled
with our proprietary models, allow us to uncover compelling investment
opportunities that others may have missed.
What we don’t do
Despite being one of the largest
investors in emerging markets, we have ruled out most EM banks from our
investable universe. Therefore, we believe it is just as important to know what
we don’t do as it is to know what we do.
Leo Tolstoy, the famous Russian
author, once wrote, “All happy families are alike; each unhappy family is
unhappy in its own way.” We would posit that all good banks are alike; each
lousy bank is lousy in its own way. While some may think that there is only one
way to practice good banking, there are numerous ways to conduct bad practice.
We will highlight two of the more serious problems in banking, which we try to
avoid at any cost.
In any bank, loan provisions are
management’s best estimate for potential losses from their lending activities.
If management is determined to print spectacular short-term earnings, they will
tend to under-report provisions by delaying recognition of bad loans. Such
delays can go on for years before the problem is admitted, and by that time, it
is often too late. This is the first and probably most common issue in banking.
The second problem arises from the
relationship between the government and the banking sector. Credit formation
usually leads to higher economic activities. Therefore, it is not uncommon to
see a government require its state-owned banks to accelerate loan growth to
support its own growth agenda. When done indiscriminately, the state-owned
banks may start to loosen their underwriting standards and accumulate loans
which may never be paid back. Sooner or later, the banks may collapse under the
weight of their own bad loans. This is essentially a classic moral hazard: These
state-owned banks don’t work for their minority shareholders (in other words, us);
they work only to support the government agenda.
It is no accident that to date, we
have avoided Chinese state-owned enterprise (SOE) banks altogether. The Chinese
SOE banks have been the Communist Party’s vehicle to fund its high-growth
agenda. Consequently, there is little guarantee on the quality of their debt
underwriting. Furthermore, “ever-greening of debt” – a practice of extending
new debt to ailing enterprises to pay for old debt – is common among the Chinese
SOE banks. The combination of aggressive loan growth and debt recycling is unsustainable
in the long run. Moreover, the asset/equity leverage ratios for Chinese SOE banks
are among the highest in the world (about 12-13x for big banks7). To put it another way, if investors
miscalculate the true loss on the banks’ assets by just 4%, half of their equity
will be wiped out.
A final approach we avoid is the
notion of making a “top-down macro bet” by buying banks, often seen as a proxy
for a country’s economic health. As investors of banks in two dozen countries, we
often get asked how we deal with macro risks. Regardless of the sector, our
longstanding philosophy on this has been the same: We invest in companies, not
countries. An unattractive bank is always unattractive to us, no matter how
great its macro wrapping looks. We will never own an inferior bank just to
participate in a superior macro story.
Our current holdings
Our two largest positions are both
Indian companies: HDFC Ltd and Kotak Mahindra Bank. These are the
highest quality financial institutions in India, in our opinion, which we
believe will continue to compound faster than the market and generate
satisfactory returns over the next decade.
In Russia, we own shares in Sberbank. We believe this is the most
under-valued and high-quality bank in emerging markets. In our view, the bank
has an envious liability franchise and under-appreciated digital capability.
There are multiple positive catalysts from top-line growth, cost reduction, and
potential multiple re-rating from a higher dividend payout.
We think FirstRand and Credicorp
are our best-in-class bets on growth normalization in South Africa and Peru, both
of which are commodity geographies. We believe there are no better large-scale
financial institutions than these two in their respective countries.
We expect that this unique portfolio
of top-quality banks can potentially outperform in the next three to five
1. Source: Sberbank and Credicorp
quarterly filings in Q3 2019
2. Source: Sberbank and Credicorp
quarterly filings in Q3 2019
3. Source: COMI Investor Presentation
in Q3 2019
4. Source: COMI Investor Presentation
in Q3 2019
5. Source: Company results
presentation in Q2 FY2020 (Sept 2019). Data are at the consolidated level.
6. Source: FirstRand results presentation in H1 FY2019 (December 2018)
7. Source: Company filings as of Q3 2019
Blog Header Image: Credit: Maksim Ozerov / Getty
9/30,19, HDFC Ltd represented 3.50%
of Invesco Oppenheimer Developing Markets Fund holdings, Kotak Mahindra Bank, 3.35%. Sberbank 0.52%, FirstRand, 2.00%,
Credicorp, 1.91%. Commercial International Bank Egypt (COMI), 0.54. It should
not be assumed that an investment in the securities identified was or will be
profitable. Companies listed are not buy/sell recommendations
interest margin is a measure of the difference between the interest income
generated and the amount of interest paid, relative to the amount of their
assets is an indicator of how profitable a company is relative to its total
deposit ratio is the ratio of a bank’s outstanding loans for a period to its
total deposit balance over the same period.
equity is the return a company requires to decide if an investment meets
capital return requirements.
Growth Model, also known as a version of the dividend discount model (DDM), is
a method for calculating the intrinsic value of a stock, exclusive of current
market conditions. The model equates this value to the present value of a
stock’s future dividends.
Price-to-book is a ratio that compares
a company’s current market price to its book value;
Price-to-equity is a ratio that
compares a company’s share price to the earnings per share.
yield is the dividend per share divided by the price per share.
The opinions referenced
above are those of the authors. These comments should not be construed as
recommendations, but as an illustration of broader themes. Forward-looking
statements are not guarantees of future results. They involve risks,
uncertainties and assumptions; there can be no assurance that actual results
will not differ materially from expectations.
The mention of specific
countries, industries, securities, issuers or sectors does not constitute a
recommendation on behalf of any fund or Invesco.
An investment in emerging market countries carries greater risks
compared to more developed economies.
general, stock values fluctuate, sometimes widely, in response to activities
specific to the company as well as general market, economic and political
risks of investing in securities of foreign issuers, including emerging market
issuers, can include fluctuations in foreign currencies, political and economic
instability, and foreign taxation issues.
may be more volatile and less liquid than traditional investments and are
subject to market, interest rate, credit, leverage, counterparty and management
risks. An investment in a derivative could lose more than the cash amount
of small and mid-sized companies tend to be more vulnerable to adverse
developments, may be more volatile, and may be illiquid or restricted as to
Fund is subject to certain other risks. Please see the current prospectus for
more information regarding the risks associated with an investment in the Fund.