Having just come out of results season for the global financial sector, in this episode, Nigel Barnes speaks to our global financials team who share their feedback from their recent company engagements. Looking at company fundamentals and valuations – investors are currently spoilt for choice in this sector.
Hello and welcome to the Denker Capital podcast. I’m very pleased today to be joined by the Denker Capital financials team, led by Kokkie Kooyman. He’s joined by Barry de Kock and Ben Kooyman. Ben came all the way from Durban – because you ran from Pietermaritzburg to Durban downhill in the Comrades this year. Ben, how did that go?
Okay… painful today. I’m glad to be done but can’t complain.
I see you have tekkies on and not slops, so the feet are obviously not feeling too bad?
Yesterday was still a 50/50 call on what to wear, but this morning I could make it into the shoes.
Okay, good. Well done on your run. I’m going to come to you first actually, because we’ve just come out of results season in the financial sector. I know you’ve been on the road a little bit. Can you give us a bit of an update as to where you’ve been and what the feedback’s been like out there in the market?
Yeah, I’ve just come from about two months in Europe – generally core Europe. This time the trip was mainly focused on the Netherlands, France, Belgium, Switzerland and Austria, and seeing the various companies there. On the ground, there’s still no sign of recession in Europe. The restaurants are full and no one’s too stressed, but there are signs coming through in terms of people being a bit worried about the gas prices going up and what that does to the household income. The companies themselves are thinking about higher interest rates, which benefits them, and how their customers will react. When I asked the companies about those two risks (recession and inflation), they see both risks as very well managed. In terms of interest rate hikes, generally consumers fix their mortgages, so they aren’t too influenced by that, and the banks benefit a lot from other spreads. In terms of the higher gas prices, it does hurt the consumer on the lower end but that’s a very small portion of their books.
The Q2 results were amazing. There are still a lot of beats from the lower provisioning, which is lower than people expected, because the market still expects a lot of bad debts which aren’t coming through. Based on the companies’ guidance and conversations with them, they see very low risk of getting that wrong at this point. They see the risks, but at the moment their books are just really well maintained. They’ve been so conservative for the last five or six years, and the European loan growth has been so low, that they haven’t been taking risks and that’s been going elsewhere. So, at this point, they are very happy about where their banks are situated. Earnings are looking good across the board. The one benefit they’ve got is that they’ve come into this situation with a lot of excess capital. So, their dividend yields can be anything from 5% to 8%. A lot of the banks have got buyback programs – they can buy back at strong valuations and those are being increased. So yeah, I think it’s been a very good set of results. Management teams are very confident and looking forward to the rest of the year.
That’s great to hear – and is very much aligned with what you as a team have been saying over the course of the last or so. Ben, were there any standouts in terms of companies in the last couple of months?
I think the European banking sector for a reason has got a very bad rap because they were struggling for a long time and they are low growth, but we’ve been investing in a new company Bawag in Austria which has done incredibly well. It listed in 2015 and we’ve been following it for the last three or four years, closer and closer. We finally took a stake in it this year and it’s a company which has done incredibly well at doing the simple things correctly and buying cheap companies and fixing them with very low costs. Returns on equity (ROEs) over the last five years have been about 16%, it’s now trading at book and it’s got a buyback program for 10% of its market cap with a dividend yield of 8%. I met the CFO there and he’s still very optimistic.
Thank you. Barry, turning to you now, because it’s also been results period for the insurance sector and I know you’ve also been looking at Latin America. Give us your feedback please if you would?
Barry de Kock:
Sure, Nigel. I would say for Q2 this year in our insurance exposure, the results were largely better than we’d expected. Part of our thesis for the last couple of years now has been that that pricing in this sector has been rising and that’s been good for underwriting margins. We continue to see that again this quarter. As, in the industry at large, prices continue to rise faster than loss costs. At our companies, it’s rising meaningfully ahead of what they estimate their lost costs are rising at.
Listening to managements on the calls and having a few calls with some of the other companies that we don’t own, the general tone from CEOs is that they are pretty confident pricing should continue to harden into next year. Given the lag between when prices go up and when we see the improvement in the loss ratio, means we should see margins continue to improve or, at the very least, stay stable for the next 12 to 18 months – which is good for the profitability and growth of the companies.
What was ahead of expectations is just how much the companies are benefiting from higher interest rates. Traditionally they are less sensitive to interest rates than banks and other more cyclical financial companies, but they do benefit. They have short duration bond-like portfolios that are rolling off and being reinvested at higher rates at the moment. I think that is now going to add to our estimates of book value growth, and I think the market is slowly realising that. Listening to management teams, they confirm once again that interest rates increasing is beneficial to net investment income, which helps the results. And, underwriting is going pretty well because there are improving the margins.
There are certainly risks around elevated frequency and severity of weather events, but that’s why we partner with what we think are the best underwriters out there. It’s what they’re paid to do and its business as usual for them. So, I think our expectations of low double-digit growth in book value per share are looking increasingly conservative if we look out another year or two.
Okay. The same question to you – any standouts in terms of companies?
Barry de Kock:
Our biggest standout this quarter would be Arch Capital. It’s one of our biggest holdings. There are three different businesses within that business: insurance, reinsurance, and mortgage insurance. The highlight there was the reserve releases in the mortgage insurance business. They’ve been ultra-conservative in reserving over the last two years, since the onset of Covid, and they are now benefiting from that conservatism as they release the redundant reserves. They also show a little bit of management class, in that they de-risk their investment portfolio well ahead of most other companies in our universe. So, when we saw the market sell off, they took much less of an impact because they’ve gone more into cash than a lot of their competitors. They are now taking advantage of low valuations in equities and bonds with that cash, and I think that will help the investment results going forward.
Excellent, thanks. And, just quickly on Latin America (Latam)?
Barry de Kock:
Latam is a small position in the fund – I think it’s around 3%. We’ve become increasingly positive on the region in absolute terms, but also on a relative basis in the last year or so. Brazil and Mexico are our preferred countries at the moment. From a currency perspective, you have attractive real yields there relative to the rest of the world – we think that should support them.
Mexico has relatively attractive fiscal dynamics and, despite all the risks around the president that came in a few years ago, it has been remarkably stable.
Brazil on the other hand is benefiting from higher commodity prices, or elevated commodity prices, even though they’ve decelerated a bit recently. That has two benefits: It benefits the terms of trade, but it also helps for tax revenues for the government. Longer term, Brazil does have an issue with their fiscal dynamics, but I think they’ve got a bit of breathing room for the next while as prices remain elevated.
Looking at the companies specifically, particularly in Brazil, there is a lot of pessimism in the valuations. And that is around macro-outlook. There are elections coming up fairly soon in Brazil so there is a bit of risk there. Our view is that the current valuations reflect most of that pessimism without any benefit to what could go right. If you look at Brazilian banks over the last decade plus, they’ve been remarkably stable in their results – through crises, economic crises, political crises and fiscal crises, the banks have been extremely strong.
We think they’re through the worst of the asset quality normalisation, let’s call it, as opposed to deterioration. Interest rates are over 13% in Brazil – high rates are also positive for banks. If we look at Brazil relative to the rest of the world, they are the one country that’s most likely ahead of inflation. So, we should see rates come down within the next year or so in Brazil. That’s good for consumers and good for growth. We’re fairly optimistic there, and that’s why we’ve added a bit to our positions.
Thanks Barry. Kokkie, coming to you now, it sounds like you might have a bit of a problem here. The team are bringing you lots of positives and ‘amazing’ Q2 results, to quote Ben. There’s a lot of good stuff coming across your desk. What have you been up to?
You summarise it very well. Looking at post 2008, or during 2008, and during the European sovereign debt crisis – you forget… in 2011 the world was really worried, and justifiably so, about Italy defaulting and Greece going under. The European banks collapsed then. I had sleepless nights during this period, literally. I had to go to a doctor to give me tablets to be able to sleep. I was trying to work out where it was going to go. This time around, I sleep very well because of the ideas that are coming through. On Ben’s recent company visits (I actually did a few in the UK before that), what was really good is that we’re finding management teams are really welcoming us. It is just so nice to be able to sit across a table again, physically. Ben got quite a few interviews with CFOs and CEOs, and what you find with sitting across a table is that before and after the discussion you start talking about the competition. You talk what other companies are doing, and that’s really exchange of information. So, this trip for Ben was really worthwhile.
Okay, so what have we been doing?
You know, when I think back in terms of what really has made Denker and Denker Global Financial Fund special is that we’re fairly small but we’ve got more than 30 years’ experience of doing this and have built up a huge network and knowledge base. So, we are always searching for opportunities that have the right quality and are in a good environment and have a good valuation. And suddenly, as you said, we are now spoiled for choice on the valuations.
The valuations are back to, in some cases, below where they were in 2011 – a time when the world was really worried. So, we are wondering if the market is right or if we’re missing something. We’re asking each management team that question as well. “What would make the market right when looking at your valuation?” South African listeners will relate this to Absa’s result – which was actually spot on in line with what we see in the rest of the world. It had a very good result, yet the price book is 1.1. So, we asked Absa’s management as well. They’ve got 4x reserves, or their bad debts are four times covered. So their bad debts could have afford to go four times higher. That’s a lot. It’s the highest in history. And then, they’ve still got more capital than they’ve ever had before – relative to the size of their book. So, we asked ourselves what would make this a bad environment, and what would make the market right globally (not only in South Africa). They went back to 2008. Just think of what was happening then because people forget it. AIG, Lehman Brothers and Washington Mutual fell over. Imagine the equivalent, in South Africa, of investors waking up or reading the Business Day the next morning and finding that Old Mutual has gone into liquidation and Investec has gone. That’s the type of environment that they’ve got reserves for – that they’ve been forced to hold reserves for.
That then leads to the second thing that leads to big bad debts, which is when you have big unemployment. Because once you’ve got an AIG falling over, you can just imagine the uncertainty and environment. So essentially, the feedback we got from all the visits, Barry’s calls and Craig’s calls with management is the market is just missing everything that has been put into place post 2008 and 2011. Absa’s management gave me a very good reminder and we’ve been hearing it everywhere – we forget (and it sounds terrible to talk about it in these terms) about the cleansing effect of Covid. There are a lot of weaker businesses that went under. Businesses that were bad at cash management didn’t have enough reserves. So, there’s a real element of survival of the strongest. Then in South Africa we’ve also had the Kwazulu Natal riots and floods (we were just there talking to the companies as well) and Comair going under. Yet, the banks are still showing bad debts of only 30 to 50 basis points. It shows the risk mitigation strategies that banks have been almost forced by regulators to employ.
So, what are we doing? We are spoilt for choice as we are really focusing on quality because we can get very good quality at low valuation. Ben saw Credit Suisse and a lot of clients are asking if they should be buying Credit Suisse. We don’t believe in buying a business that is very cheap but the culture is just wrong. You can see in everything that’s been happening there, there’s a bad culture and it’s going to be a long time before it can be turned around. There are better opportunities at the moment, such as Citigroup, which I think is now our second largest holding and trading at a 0.55 price to book. It’s doing a return on capital of between 9% and 11%. The market is just focusing on the past, but the management team are where Credit Suisse will hopefully be in 10 years’ time. For 10 years, they’ve been turning the business around and disposing of non-core assets. So, it’s that type of business we’ve been adding to the whole time.
We know all the companies we invest in very well. In fact, one of the top three positions in the fund is LIC Housing Finance in India. We’ve been meeting with them every year since 2003. For 22 years they’ve grown their net asset value per share and dividend per share every year. Yet, it’s now trading at 0.7. India is the fastest growing country in the world – with a nominal growth rate of 12% (6% real, 6% inflation) and bad debts are low- but the market is just scared.
Gradually what we’ve been doing is adding a bit to Brazil. Brazil reminds me of when we went in 2002/3 – there is so much pessimism and the banks are good quality. Itau is amongst the best banks in the world. You could compare them to the FirstRand of South Africa. So, we’ve been adding a bit there – also to reduce Europe a bit. In Europe the banks are cheap, but it is a low growth environment. Whereas the Brazilian, Indian and Indonesian banks (we haven’t even got time to talk about Indonesia) can do very well. Those are three countries we are focusing on, where the backdrop environment is still good. You could see strong growth again in those countries and valuations.
A good quick example is Georgia. We’ve held the two Georgian banks for at least five years. They really got sold off when Russia invaded Ukraine – everybody thought they were going to take Georgia while they were at it. The Georgian banks have gone up, I think, 60% in the last five weeks or so. They’re amazing performers. They were so cheap, and we were looking at each other in meetings asking if we should add more and decided it was too risky. Fortunately, we did add a bit more. That was a 5% position in the fund, which is fairly big. Georgia is a wonderful country doing very well. They haven’t got problems with electricity because they’ve got hydro power, and they’re getting big benefit from Ukrainian refugees.
So, we’re actually spoilt for choice – but slowly keeping Europe low. At each meeting we discuss if we should take Europe exposure lower because of the potential recession. But in my 35 years of experience, I’ve found that when valuations are this low the chemicals in your brain start changing and you get too negative. Then the unexpected happens. You can have a 30% rally before you know it. Looking back, we actually reduced Europe gradually a bit, added to India and Brazil and kept our insurance holdings quite stable. We also reduced JP Morgan and ING a bit and then went into counters like Citigroup that are even cheaper – and where our meetings show that management teams are doing very well.
When I talk to you guys about the global exposure, the true global exposure you have in the fund always comes across. You talk about countries like Georgia, India, other parts of Europe, and the UK. What also comes across is the fundamental research and bottom up processes that you go through. The feedback that we’re getting from you today is aligned with what you’ve been saying for the last little while around how these companies are positioned and how the regulators have driven them to position themselves the way are. All we need is market sentiment to catch up.
This has been very insightful, thank you. Ben – good luck with your recovery. Barry, thanks for your input on the insurance and Latam side. Kokkie, good luck for the rest of the year. I’m sure we’ll do another podcast with you before the end of the year. Like a Comrades, it’s not a sprint. It takes time. It takes patience and hopefully the market catches up.
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