Banks are not our preferred stocks to be long equities. The excessively leveraged balance sheets of the banking business make us feel uneasy with the sector, as returns on equity (ROE) typically veil low returns on assets (ROA). Since analysts and the market seem to perpetually focus on ROE rather than on ROA, banking sector managers have a strong incentive to keep leveraging up the balances to leverage up their stock prices and their paychecks. The risks inherent to excess leverage became evident during the financial crisis: relatively small losses on asset values led to the complete wipe out of shareholders’ equity.
In Latin America, the situation evolved quite differently. Banks have typically had substantially lower leverage levels than their counterparts in the developed countries, have stayed focused on the traditional intermediation business, and have enjoyed high margins and ROEs. Brazilian banks became the model to follow in the 1990s and 2000s. Throughout those years, Brazil's largest banks boasted ROEs north of 30% and their stocks rewarded investors with an impressive return.
Rate Cuts Pressure Margins
However, times began to change for Brazilian banks two years ago. Increasingly, emerging markets were becoming a mainstream investment destination, and competition from cheap foreign sources of financing started to put pressure on their margins. Banks were further squeezed when the Brazilian government decided on two procedures to rein in the interest rates charged by banks for their loans.
First, the central bank’s reference rate, known as SELIC, was cut significantly. Historically much higher than inflation, the SELIC provided an excellent way for banks to earn huge margins without taking on too much risk. Banks could earn 10% interest spreads by simply lending to the Brazilian central bank or buying government paper. This has ended. The government’s push for the central bank to lower the reference rate has led to a 525 bps decline since early 2011 (chart below).
The revenue loss that resulted pushed banks to grow their exposure to riskier private sector borrowers – particularly to individuals through credit cards and vehicle loans. Bank loans grew more than 20% in 2010 and 2011, and helped contain the drop in margins.
However, an unintended (though not unanticipated) consequence was a sharp increase in the number of delinquent loans and in the charges to the income statement. In the end, ROEs where slashed from the 30%+ level to the 20% area. Yet, bank stocks remained the darlings of Wall Street research throughout much of 2011, despite the obvious pressure on margins, asset quality and, ultimately, overall profitability. This may explain why stocks only reflected the new, lower ROE levels in 2012 – when stock prices have been slashed.
More Bad News
Making things worse, the Brazilian government also began to target private sector lending rates through public sector-owned banks Banco do Brasil and Caixa Economica Federal. Both banks embarked on a steady cut in lending rates over the last twelve months – gaining market share and coercing private sector banks to follow pace. We're at the point where pressure on interest rates makes the daily headlines in the Brazilian press, and Wall Street analysts have thrown in the towel on the sector – becoming overly bearish.
The change in sentiment towards Brazilian banks in general may have come too late (again). In its search for an alternative, the mainstream has grown overly optimistic with Mexican banks – and forecast them to grow their loans and profitability. However, we have heard these same prophecies repeatedly over the last two decades, and have grown skeptical of the Mexican banks’ ability to fulfill them.
Claudio Maulhardt is a partner and portfolio manager at Copernico Capital Partners, a hedge fund manager headquartered in Buenos Aires, Argentina, with a Latin America geographic focus. Claudio joined Copernico in 2003 following ten years as a senior equity research analyst for Latin America at ABN AMRO in Buenos Aires and New York, and at Banco Republica in Buenos Aires. Claudio graduated from the Universidad de Buenos Aires in economics. Contact: firstname.lastname@example.org
This article was featured in the October issue of World Money Analyst. In fairness to our paid subscribers, the article has been edited to remove proprietary content. But we can tell you that the analyst names one bank in particular that is set for profits, as well as a long-short strategy using Mexican banks that look overrated and overpriced. To see the full article where we name names, as well as gain access to the complete archives of World Money Analyst, you can give the letter a no-obligation test drive by clicking here.
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