Quarterly Strategy Note Q1 2018

Transcription

1 Neil Brown & Richard Hasson Co-Heads Quarterly Strategy Note Q IS CAPITEC THE NEXT AFRICAN BANK? by Richard Hasson Introduction In August 2014 we wrote a note to stakeholders highlighting 10 key reasons why we did not own African Bank shares in our client portfolios, and why we had no intention of buying any shares despite their 90% share price decline at that time. Chart 1 In this Strategy Note we will revisit those 10 key reasons/concerns for not owning African Bank (ABL) and analyse whether these reasons still hold for us not owning Capitec shares in our client portfolios. African Bank Concern 1 the high rate of growth and absolute size of the microlending industry in South Africa The Personal Loans market in South Africa is currently a R186bn market and comprises 12% of the R1547bn Retail lending market. As can be seen from Chart 1 below, the Personal Loans market grew rapidly from and this rapid growth was a key concern of ours in 2014, and part of the reasoning why we did not own African Bank or Capitec at the time. In analysing numerous historical global banking cycles, it is the aggressive growth in lending that creates and hides problems such as unsustainable asset price bubbles, inability to repay loans, low-rate lending, rescheduling/loan consolidations, etc. This aggressive loan growth and/or asset bubble, allows borrowers to kick the can down the road, and it is only once this aggressive growth in loans slows down that the true impact of this growth can be assessed. A good example of this type of destructive cycle would be the US housing market bubble in , with its no income, no job and no assets (NINJA) housing loans. However, from Chart 1 it is evident that Retail lending, and especially the Personal Loans category, have not been growing aggressively since 2014, so the likelihood of there currently being a bad debt problem or an asset bubble waiting to surface is therefore minimised. Cross referencing this low credit growth in Chart 1 to South African Consumer Household Debt to Disposable Income Ratio (Refer Chart 2A) also shows that despite a weak economy impacting the GDP denominator, households have been degearing their balance sheets and real lending (i.e. adjusted for inflation), per Chart 2B, has shown negative growth over the last three years. Consumer balance sheets are therefore, in aggregate, in much better condition than in Chart 2A Chart 2B Source: Source: FactSet, Electus Fund Managers Source: FactSet, Electus Fund Managers 1

2 Within the Personal Loans sector, Refer Chart 3, Capitec (CPI) and FirstRand (FSR) have been the most aggressive since the demise of African Bank (ABL) in mid-2014, however their Personal Loan growth rates have not been at unsustainably high levels in recent years to raise concerns. Chart 4 In the following charts, Barclays Africa Group Limited is BGA, FirstRand is FSR, Nedbank is NED, Standard Bank is SBK, Capitec is CPI and African Bank is ABL. Chart 3 Chart 5 Capitec s market share within the Personal loans industry has grown to 25% (Refer Chart 4), a level we would consider mature relative to its physical presence. This maturity has resulted in its need to diversify into other product areas and Capitec successfully launched its credit card in 2017 and already has a 2% market share of advances in this category. We do however believe that Capitec s high market share in Personal Loans (Refer Chart 4), and the additional system and people costs required for rolling out additional products, bringing additional complexity to their business, will dampen future profit growth levels. In analysing Capitec s share of the SA Retail Banking market, per Chart 5, we see that Capitec already has a large share at over 10% of the SA Retail Banking profit pool, which includes Business Banking per the company specific disclosures. Based on our best estimates of stripping out Business Banking from Standard Bank (SBK), Nedbank (NED) and Barclays Africa Group (BGA) earnings, we believe Capitec s Adjusted Market Share of pure SA Retail banking profits is already close to 14% indicating a level of maturity which will result in Capitec achieving lower earnings growth over the next 5 years than what it achieved over the last 5 years. Source: Company Reports, Electus Fund Managers estimates In Capitec s recent year end results to February 2018 (FY2018), Capitec s growth in personal loans has been to clients with Gross Incomes of over R pm which now makes up 58% of new Personal Loan sales. This is a remarkable achievement for a business that was initially launched as a short term microlender and shows the success that they have achieved in migrating the business model to also become a middle market main street bank for those clients. For the Personal Loans industry in SA in Calendar 2017, loans to clients with Gross Income levels of below R pm actually declined as banks pulled back from these perceived riskier clients. Capitec s diversification of its client base has therefore been a successful strategy. Their current stated strategy is to focus on the higher income market with longer term loans and reduced pricing, which will result in lower yields as already evidenced in FY2018, as these loans are in more competitive markets, such as vehicle financing. In the medium term we continue to believe that management s target of 25% Return on Equity (ROE) is achievable, due to strong transactional fee income growth. 2

3 African Bank Concern 2 African Bank s exposure to the creditbased furniture retail industry This is not a concern for Capitec as they have no industry exposure outside of their core focus area of offering products in transacting, lending, saving and insuring to their customers. African Bank Concern 3 African Bank s growth in loan size and duration was well ahead of any previous experience One area where Capitec has shown a similar trend to African Bank has been in the growth of their average loan size and duration/term. This is partly understandable as they have moved to higher income clients, but even within these customers there is a trend of higher average balances. While averages can be distorting to the underlying business performance, this is certainly a risk area we will continue to monitor in the periods ahead. These higher income clients are in a market that is also more competitive hence pressure on net interest margins is expected to continue. A lower average loan size was disclosed by Capitec in FY2018, but this was due to growth in their credit card book and how these clients were recorded. Actual loan size, for greater than 6-month clients, grew from R to R32 000, and especially high growth was seen in month clients. Therefore, the trend of higher loan size and longer term remains a potential risk factor for us to continue monitoring closely. African Bank Concern 4 the uncertainty in the bad debt profile in African Bank as the rate of aggressive lending growth slowed This is not a major concern currently for Capitec as per Chart 3, the rate of loan growth has already slowed down to more normalised levels over the last 3 years Arrears in Capitec have been trending lower which is a positive, as it is an indicator of a better book quality. Arrears look very low relative to peers, but this is due to Capitec s aggressive write off policy where loans which are 3 months in arrears are written off for accounting purposes, and provisions comfortably cover arrears and all rescheduled loans. African Bank Concern 5 African Bank s inadequate levels of capital and continuous need for rights issues Capitec s Common Equity Tier 1 ratio of 34% is well above regulatory requirements and sufficient to fund growth in advances over the medium term. With a high Return on Equity (ROE), of around 25%, and a low level of advances growth (where regulatory capital is required to partly fund this growth), Capitec will continue to generate excess capital over the medium term. There is even the potential that they increase their dividend pay-out ratio from the current 38% to avoid further build-up of excess capital. African Bank Concern 6 were repayments by African Bank s clients affordable? Capitec applies 3 parallel disposable income calculations to ensure that their clients can repay their loans, and ultimately Capitec applies the most stringent of these calculations. These 3 calculations are the National Credit Act (NCA) affordability calculation, a Capitec client disposable income calculation and the client s own calculation. Branch staff have no credit granting discretion and processes are rules based. In addition, having 9.9 million clients enables Capitec to analyse both the financial health of the client and trends in the client s data to support credit granting appetite and hence identify risk areas and opportunities. Approval rates have however declined from over 50% in 2016 to under 30% currently, resulting in lower take up rates, showing that affordability has become an issue in the current difficult economic environment. African Bank Concern 7 would regulation of the credit life industry impact profits? Credit life insurance charges were a key part of African Bank s profits and these were at very high rates, that in 2014 were potentially subject to regulation. Since 2014, these insurance charge rates have in fact been regulated to much lower levels than the industry charged at the time. Capitec, however did not previously charge clients separately for credit life so this was not a risk for them. After the Credit Life regulation, Capitec now separately charges clients for credit life and have used these proceeds to partly offset the impact of interest rate caps on the industry. African Bank Concern 8 provisioning policies at African Bank were not in line with other industry players e.g. Capitec Capitec s write off policy under IAS 39 included provisioning on their up-to-date book, where they apply an incurred but not reported (IBNR) provision for the emergence period of the first 3 months of a new loan. Capitec s policy is to provide for 8% on up-to-date clients, 42% on 1 payment in arrears, 78% for 2 payments in arrears, 88% for 3 payments in arrears, and 100% thereafter. Also, when a client reschedules an existing loan from arrears, Capitec do not reduce the provisions in place even though the models show the likelihood of a better recovery rate. Capitec also treat partial payments as nonpayment for provisioning purposes and provisions are raised at client level not product level, so if a client is in arrears on 1 product then they will treat all that client s products as in arrears. Capitec s level of Balance Sheet provisions (Refer Chart 6) have been continuously increasing and their coverage of all loans in arrears and all rescheduled loans is at 115%, which we consider sufficient. Therefore, our concerns about African Bank bad debt provisioning policies are not a concern at Capitec. Under IFRS 9, which will be introduced in FY2019, the 3- month emergence period mentioned above will change to a 12-month emergence period. This will require an additional R m of bad debt provisions but will be charged to retained earnings and not to FY2019 profits. This will result in a 3-4% impairment to net asset value, which we do not consider material, and Capitec certainly has sufficient levels of excess capital to deal with this additional impairment. 3

4 Chart 6 African Bank Concern 9 African Bank s business model relied on wholesale funding as it had no deposit taking franchise Capitec has R64bn of deposits, where unlike African Bank, R58bn of these deposits are retail deposits of which R22bn has an 18-month duration. Retail deposit market share has shown a continuously increasing trend since 2008 (Refer Chart 7), showing that trust in the brand is strong. Wholesale funding, which is typically more expensive than retail funding, has been managed down from 40% of funding in 2014 to 10% in Liquidity management is also conservative with Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR) both well ahead of regulatory requirements. This deposit taking franchise of Capitec has clear value to shareholders as both an income generator as a cheaper source of funding, but especially to mitigate the risk of large wholesale deposit withdrawals. Chart 7 African Bank Concern 10 African Bank had a mono-line income stream in a risky industry This risk does not exist in Capitec as it has successfully built up a large transactional fee income of R5.1bn in FY2018 which was 41% of net income and covers 81% of expenses. In FY2018 fee income grew 30% as Capitec grew to 10m clients of which 2.6m are considered quality clients (frequent transactions). At an effective 26% penetration of their client base this allows further penetration of banking product, as well as expanding into other products such as sales of insurance products. Insurance products, such as funeral policies, are likely to be successful as they are being launched 30% cheaper than market leaders. Capitec s credit card launch has also been successful, achieving a 1.9% market share of advances and 27% of new cards granted in Therefore, Capitec has managed to diversify itself away from having a profit stream largely based on interest income on microloans, to a diversified income stream including transactional fee income, a client base that spans across entry level and middle market clients, and a deposit franchise that generates its own income stream. Conclusion and why we don t own Capitec in our client portfolios In summary, most of the concerns that we had about African Bank are not concerns at Capitec, hence the answer to our initial question is NO, and Capitec is not the next African Bank. Most notably, we believe that Capitec s conservative bad debt provisioning policies and its diversified income streams and deposit taking franchise are key differentiators to that of African Bank. Capitec generates a Return on Equity (ROE) of over 25% and has certainly disrupted the SA retail banking market and hence we can comfortably call Capitec a high-quality business, which fits in with our Electus philosophy of investing in high quality businesses. Where Capitec does not meet our Electus investment philosophy is that those quality businesses also need to be attractively priced, and at current share price levels, Capitec is trading on a 22x Price: Earnings multiple (historic to February 2018) and a Price: Book ratio of 5.3x, both of which we consider expensive. We believe that a more appropriate Price: Book multiple for Capitec is 3.4x its Net Asset Value, based on a 25% Return on Equity, 13% Cost of equity and 8% growth into perpetuity. This 3.4x multiplied by Capitec s Net Asset Value of R162 per share results in a valuation of R550, which equates to a historic Price: Earnings multiple of 14.4x, a level we would consider more reasonable for this high quality business.. 4

5 ELECTUS FUND MANAGEMENT OVERVIEW by Neil Brown and Richard Hasson Electus Fund Management Overview As discussed previously, Electus incorporates our macro frameworks of targeted top-down global and South African research, with our broad and in-depth bottom-up industry and company specific research. This enables us to have our own normalised forecasts and valuations, allowing us to build risk managed Funds on a bottom-up basis, normally consisting of ±30 JSE listed shares. The Electus managed Funds are managed as style agnostic and diversified Funds, with the goal of strongly growing clients invested capital over the longer-term. In order to deliver this strong capital growth, we have a positive bias towards investing in best-in-class companies that are managed by proven management teams and are trading at attractive valuations. The Funds are market cap indifferent in their share selection, normally having meaningful exposure to high quality, mid-sized, but market leading, South African financial and industrial businesses. Financial Market Overview Global Financial Markets: Following the global financial crisis in late-2008, the quantitative easing in developed market economies led to extremely low interest rates in these economies. This low cost of borrowing meant that many corporates could easily increase their levels of debt, doing share buybacks and M&A with the proceeds, without spending capex, or hiring new staff, and without really growing the economy. The problem for both equity and bond markets, is that this 9-year period described above is in the process of slowly ending and normalising. The above environment created a great deal of investor complacency, with borrowers becoming too aggressive in their investment strategies, highlighted by an ever-increasing mis-allocation of investors capital. This seemed to peak at the end of 2017 and was very visible by the record low levels of the VIX, which is a measure of implied volatility of the S&P 500, in European corporate junk bonds, which are expensive and trading at the same levels as the US Treasury 10-year bond and in the Bitcoin bubble, the major digital cryptocurrency which uses the blockchain technology. Since early 2009, while top line sales did not increase materially, the operating margins improved to historically high levels and together with the share buybacks, the earnings per share (EPS) improved. In turn, this led to a very strong equity market performance in the USA, where the key equity market, the S&P 500, has risen by 300% off its lows of March The S&P 500 index now trades on a 12-month forward Price/Earnings (P/E) multiple of 16.5x, which may not seem overly expensive, but it does incorporate the fact that the S&P 500 s consensus EPS growth rate for 2018 is forecast to be a very high 20%, leaving no room for disappointing corporate profit growth. While the emerging market economies did not benefit from the extremely low interest rates described above, their equity markets have benefitted from strong inflows, especially from passive exchange traded funds (ETF s). At the same time, emerging market bond markets have benefitted from inflows that are hunting for high yield, due to the extremely low yields in the developed world bond markets. The full evidence of this mis-allocation of capital is starting to be seen but will only be truly visible over the next few years when gradually rising inflation will cause interest rates to rise and normalise. We believe that based on the above, global equity markets are fully valued, making it very important how we manage the risk in client s SA equity funds. South African Financial Markets: As mentioned in Q4 2017, we believe that most consumer related, domestically-biased, shares in SA are currently overpriced on the JSE and this is mainly due to their lack of ability to grow their SA based profits at rates that justify their current valuations. Now that we are in the process of moving through positive leadership change in SA Government and SOE s, we will soon return the focus onto the ability to improve the structure and strength of the SA economy. SA has had a weak economy since about 2008, which coincided with the Global Financial Crisis, the end of the commodity cycle and the Eskom power blackouts. Without another strong commodity cycle, for the SA economy to grow consistently above ±2.5%, it needs structural change in order to become globally competitive. Governance, leadership and productivity improvements are needed in the over-staffed public sector and SOE s, while education, skills and labour flexibility must also be meaningfully improved. At the current strong levels of the Rand, with our high base of unskilled and semi-skilled labour and very rigid labour laws, we are not very competitive on a global basis. These are the key challenges facing Cyril Ramaphosa as he transitions into the SA Presidency and, with a high level of unemployment and a key election in 2019, they are not easily solved. We believe that the foreigners, and the high level of the domestically-biased consumer shares on the JSE, are currently overestimating the likelihood and timing of these potential benefits. As we are all aware, the short-term is always driven by momentum, themes and the re-rating or de-rating of the equity market and this is prevalent in the current environment. However, when investing in Electus managed Funds for the medium and longer-term, the importance of company profits, their normalisation, and company valuations are most important in terms of returns, while the structure and strength of the SA economy is also an important influence on company profits. Responsible Investing and Corporate Governance Following the Steinhoff collapse in December 2017, there was only one event in Q where we had concerns related to aspects of Responsible Investing and Corporate Governance and this was in the Resilient group of property companies. The 5

6 Electus managed Funds have never owned Resilient or any of its related companies, being Fortress, NEPI Rockcastle and Greenbay, and while the shares now seem to be slightly undervalued, we will not invest in them until we see less aggressive investment strategies and the outcome of investigations into potential problems relating to share trading. Fund Performance The Electus managed Funds have performed very well on a relative basis in Q1 2018, which has also meaningfully improved their performance for the past 12 months. With the Electus team being solely focused on managing SA equities, we have an excellent understanding of 110 SA listed companies, many of which are quality mid-sized, but market leading, South African financial and industrial businesses. Many of these companies are not followed by the foreign based investors, but these companies have also been neglected for a couple of years by most SA based investors. The recent good relative performance of the Electus managed Funds has been helped by these quality companies such as Clientele, Combined Motor Holdings, Italtile and Hudaco, all of which have been held in the Funds for at least 10 years. from specific share selection and not from sector selection. In terms of the Electus managed Funds positioning, with global financial market risk and a more volatile currency and equity market, we believe that good share selection is critical for success in Therefore, we remain focused on investing in best-in-class businesses with zero tolerance for poor businesses, with the Funds always targeting being >98% invested. In the Financial sector, we are finding little value in domestic banks and better value in Investec and selected Life Assurance companies. In the Industrial sector, we believe that most of the SA s domesticbiased consumer shares are overpriced, with only a few midsized companies such as Italtile and Combined Motor Holdings, as well as the larger Tiger Brands, offering value. Following the recent Rand strength and a fall in their share prices, there is some value returning to selected large Industrial rand-hedge consumer businesses, such as Naspers and British American Tobacco. In the Resource related sector, we prefer the diversified mining shares, such as Anglo American, BHP Billiton and Glencore, as well as Sasol. We believe that with a renewed belief in the South African government leadership and domestic economy, having the ability to selectively invest across quality mid-sized South African financial and industrial businesses will be a key differentiator for Electus and the Funds we manage for Clients in the coming years. It should be noted that Electus staff have always analysed companies and managed the Funds for Clients on a very consistent basis and this is how we have obtained excess returns in the Long Funds of >1.5% per annum for our unbroken 17-year track record vs the major JSE indices and our SA Equity peer group. Importantly, these excess returns have come with our proven risk management, which is highlighted by having an excellent longterm Sharpe ratio (return per unit of risk) of 0.73 and best-in-class low levels of volatility. Fund Positioning Based on our Electus bottom-up aggregation of valuations for SA s 110 largest companies that we analyse, following the equity market weakness since late-january 2018, the main JSE indices are now trading 6% below their appropriate price levels. We have been using this normalised methodology for determining the fair level of the SA equity market since the beginning of 2009 and it has proven to be very accurate. In contrast, the well diversified full discretion Electus managed Funds are undervalued with current upside of 30%, which would suggest above average absolute and relative prospective returns. As we wish to maintain a high level of Active Share and Tracking Error risk in the well diversified full discretion Electus managed Funds, we currently only hold 25 shares, with all shares having a targeted weight of >2.0%. This clear focus and positioning, with suitable diversification and strong risk management, enables us to target excess returns for clients 6

7 Chart 8: Long-Term Performance History vs Peers Nedgroup Investments Growth Fund (Unit Trust) to Excess Return pa vs General Equity Unit Trust Peer Group of 1.6% (Net vs Net) Since managed by Neil Brown and Richard Hasson Source: Morningstar and Electus Chart 9: Long-Term Performance History vs JSE Nedgroup Investments Growth Fund (Unit Trust) to Excess Return pa vs FTSE/JSE Capped SWIX of 1.5% (Gross vs Gross) Since managed by Neil Brown and Richard Hasson Source: Morningstar and Electus Electus Fund Managers Proprietary Limited (Reg No 2014/268056/07), an authorised financial services provider (FSP 46077) approved by the Registrar of Financial Services Providers ( to provide intermediary and advisory services in terms of the Financial Advisory and Intermediary Services Act, 37 of Electus Fund Managers Proprietary Limited ( Electus ) has comprehensive crime and professional indemnity insurance. For more detail, as well as for information on how to contact us and on how to access information please visit The content and information provided are owned by Electus and are protected by copyright and other intellectual property laws. All rights not expressly granted are reserved. The content and information may not be reproduced or distributed without the prior written consent of Electus. The content of this presentation is provided by Electus as general information about the company and its products and services. Electus does not guarantee the suitability or potential value of any information or particular investment source. Market fluctuations and changes in rates of exchange or taxation may have an effect on the value, price or income of investments. Since the performance of financial markets fluctuates, an investor may not get back the full amount invested. Past performance is not necessarily a guide to future investment performance. The information provided is not intended nor does it constitute financial, tax, legal, investment, or other advice. Nothing contained in the presentation constitutes a solicitation, recommendation, endorsement or offer by Electus, but shall merely be deemed to be an invitation to do business. Electus has taken and will continue to take care that all information provided, in so far as this is under its control, is true and correct. However, Electus shall not be responsible for and therefore disclaims any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable, directly or indirectly, to the use of or reliance upon any information provided. CONTACT DETAILS: GREAT WESTERFORD BUILDING, 240 MAIN ROAD, NEWLANDS, CAPE TOWN 7700 TELEPHONE NUMBER: WEBSITE ADDRESS 7