JOHANNESBURG - Government's expected announcements turned out to be a damp squib so far, but at least South Africa can breathe again after Moody’s decided not to downgrade us on Friday and we have reason to smile after the Rugby World Cup. We may also celebrate in the markets soon.
Some sectors of the JSE suffered badly after Ramaphoria faded since the end of the first quarter last year and are likely to regain some lustre until Moody’s revisits us in March next year. From a valuation point of view the JSE banking sector looks particularly attractive.
The price-to-earnings ratio of the FTSE-JSE Bank Index fell from a high of nearly 15 times trailing 12-month earnings to 11 times, and it appears that the market has fully priced in a rating cut.
The ratings of banking shares are to some extent dependent on long-term government bond rates. When the market is over-optimistic the earnings yields of banking shares fall way below the 10-year government bond yield and vice versa draw level with bond yields specifically when the latter is in an upward trend.
At this stage the earnings yield of the FTSE-JSE Banks Index is currently at 9.2percent and reflects the current yield on South Africa’s 10-year Government Bond (SAGB10).
It is also within a mere 80 basis points of the 2016 highs.
To get an overview of the banking sector I consolidated the financial results and financial position of the big 5 banks in South Africa: Absa Group, Capitec, Nedbank Group, FirstRand and Standard Bank and where applicable, I have annualised the interim results to June 2019.
Currently the big 5 are collectively trading at a price-to-book value of 2.1 and compare to an average of 2.0 since 2012 where calendar year-end prices were used.
On a price-to-earnings ratio basis the big five are collectively trading at 12 times trailing 12-month earnings and compare to an average of 12.0 since 2012.
It is, however, apparent that the growth in shareholders’ interest has slowed to about 5percent compared to more than 10percent per year since 2011.
The collective return on equity (shareholders’ interest) in 2019 is likely to match the average since 2012 of around 17percent.
It is evident that profitability and growth play a major role in the market’s valuation of banking shares.
Capitec’s ability to consistently achieve returns on equity of 20percent plus is rewarded by the market with a premium rating of seven times book value and a price-to-earnings ratio of 28.
The company continues to surprise the market on the upside, due to innovative initiatives to diversify income streams.
In sharp contrast, Absa trades at only 1.3 times book value due to pedestrian growth and return on equity barely exceeding long-term government bond rates.
It is no wonder that the bank’s rating as measured by Absa’s earnings yield almost always exceeded the SAGB10 yield.
Apart from a ratings cut being priced in the valuation of the banking sector as such, it does seem that the market has penalised some banking shares too much. Absa at a yield of 11.2percent is 2percent higher than the SAGB10 yield.
Standard Bank's earnings yield of 10.25percent is 1percent higher than the SAGB10 yield - the highest since June 2017. Nedbank’s 12.15percent is 3percent above the SAGB10 yield - the highest since June 2016.
While the banking shares are not totally down and out - there are still risks on the downside - it does seem that there is some value around specifically the lowly rated stocks. In comparison to the rest of the South African equity market, the Bank’s Index is trading at a 55percent discount to industrials - the highest discount since December 2017.
Yes, banking in South Africa is changing rapidly due to technologies and client demands. Furthermore, due to the weak economy the competition between banks and newcomers will impact on banking shares. But there is a price for everything.
Ryk de Klerk is analyst-at-large. Contact [email protected] His views expressed above are his own. You should consult your broker and/or investment adviser for advice.