Seeking value in dominant banks
Australian banks of 1990s versus today's bargains
Australian investors typically have a substantial allocation to bank shares whether directly or via superannuation or holdings in index funds such as the ASX all ordinaries index (of which financials make up 34%). The banking sector has experienced incredible growth over the last 20 years. The banks are now large companies even as measured on a worldwide scale:
Owning the big Australian banks have been incredibly rewarding for investors. The highly concentrated banking market has resulted in muted competition and very high margins. Although owning the banks over the past few decades was fulfilling, purchasing the banks during the misery of Australia’s banking crisis of the early 1990s was a truly great value investment opportunity. It can be instructive to review such case studies to gain an additional perspective when considering a current prospective investment.
Australian banks in the 1990s
Following the deregulation of the Australian banking system in the 1980s competition between banks increased dramatically driving a huge growth in lending. Towards the end of 1989, the Reserve Bank raised the interest rates and property prices fell. This caused significant losses to the banks with the ratio of non-performing loans increasing to 6% and write-offs totalling over $9 billion.
Faced with such levels of losses, banks closed non-performing branches and reduced staff levels. Shareholder dividends were also reduced. Investors abandoned the sector in the face of such uncertainty. The overall bank sector could have been purchased for 6x its then level of depressed earnings. Over the following years profitability returned and the sector underwent a meaningful turnaround. Bad debt ratios decreased and deposit ratios increased. The widespread adoption of technological innovations allowed management to reduce operating costs. As the following graph illustrates, the profitability as measured by return on equity quickly regained previous levels.
In the following decade, banks increased in value as loan growth was supported by the Australian consumer’s growing willingness to incur greater levels of leverage. Between 1990 and 2007, Australians borrowed $1.50 for every $1 of disposable income. The term drop in interest rates further encouraged higher borrowing levels and lower default rates as a property boom took hold.
Rather than purchasing Australian banks at current valuations, investors may be better served by looking abroad at a similarly dominant financial institution but which can be purchased at a valuation closer to Australian banks in the early 1990s; Sberbank of Russia.
Sberbank: a dominant bank at a bargain price
By the end of 2014, the Russian economy was experiencing the worst conditions since the Russian financial crisis in 1998. The sanctions imposed by the West and the fall in the oil price were the root causes of the Russian crisis. The Russian Rouble fell sharply and the inflation rate increased to over 9%.
In order to reduce the inflation rate and lift up the Ruble the federal Russian bank raised the official interest rate up to 10.5%.
Sberbank is the biggest bank in Russia with 10 times the number of branches than its nearest competitor. Due its large and cheap deposit base and the high interest rate on the loans the bank maintains an incredibly high net interest margin. Despite the stock price falling by 50% in US dollar terms, Sberbank remained profitable. In the beginning of the 2015 at the nadir of the crisis when the market capitalisation reached US$23 billion, the shares were trading on the market at 4 times earnings. As the crisis has dissipated, Sberbank’s shares have increased from 54.90 Ruble to the current price of 158 Ruble.
The bottom line
As event driven value investors we seek to invest in dominant banks whose valuations are closer to the Australian banks of the early 1990s rather than at today’s prices. To successfully identify such compelling investments requires a global approach as the best bargains to be found may not be on the ASX.