Still-strong investment case for SA banks despite rising risks

South African bank shares took a knock in May as the FTSE/JSE Financials Index returned -7.9%, underperforming what was a broadly weaker market. This came on the back of elevated geopolitical risk as a result of growing investor concerns over possible sanctions from the West over the government’s seemingly pro-Russia stance, and follows South Africa’s grey-listing by FATF and a gloomy outlook for the local economy, all factors heightening the country’s perceived investment risk.

In our view, this sell-off was overdone. SA banks still represent attractive investment opportunities despite the higher risks facing them and the country more generally. Banks are well-provisioned, now holding around 1% higher provisions versus their assets compared to previous financial cycles, which means that they can comfortably absorb a doubling in their provisions over one year, a highly unlikely scenario. Equally, if provision charges are merely elevated (at around 20bps above through-the-cycle levels), they can handle five years’ worth of elevated impairment charges – another scenario that is very unlikely. South African banks have a history of being conservative in their provisions, often overproviding for expected bad loans, only to have actual losses be lower than those provided for, and this is likely to be the case going forward.

Banks’ earnings continue to benefit from rising local interest rates as they receive higher interest on their loans, termed the “endowment effect”, helping to offset rising client defaults. They have also experienced reasonably robust levels of asset growth in the past year, and amid the general inflation have some ability to pass on price increases to clients, helping to improve topline growth. Along with cost-cutting, these factors have helped banks maintain or improve their return on equity (ROE), despite the difficult operating environment. With their robust levels of capital and extra provisioning on their balance sheets to offer protection, we believe they can weather the storm.

This is even more true for banks with operations outside South Africa such as Absa and Standard Bank, in countries with better growth prospects where investors can benefit from the diversification benefits. While there are pockets of idiosyncratic risk, such as Ghana and potential investor concerns around Kenya, we think that the growth from other African countries (ex-South Africa) should continue to materialize and contribute to overall group growth.

Lastly, but most importantly, banks’ valuations are very attractive, with the sector currently trading on a 1.2X price-to-book value (P/B) ratio. In our view, the market has over-reacted to the negative sentiment. For example, Absa is trading at a discount to its book value at 0.9X despite having reported a return on equity of 17%, while Standard Bank is at a P/B ratio of 1.1X. Meanwhile, both are offering high-single-digit dividend yields. Any re-rating by the market will result in excellent above-market returns, making for a strong investment case for SA banks despite the poor conditions. For those investors holding banking shares, patience should be very well rewarded.