This article is authored by MOI Global instructor Steve Gorelik, Portfolio Manager at Firebird Management, based in New York.
In his book Value Investing: From Graham to Buffett and Beyond, Bruce Greenwald described the evolution of value investing from “net-net” asset-based analysis to a focus on franchise value and moats, a strategy popularized by Warren Buffett. Over the years, value investors as a group became more comfortable with paying for growth especially in companies with visible competitive advantages. The shift towards quality investing has accelerated in the last few years as many old economy companies did not adapt to a changing competitive landscape and therefore became value traps.
As the thinking of fundamentals-focused investors has evolved, a new holy grail has emerged – the “ Cheap Compounder.” Who wouldn’t want to own a company that grows earnings by reinvesting capital into its business at high incremental returns while also trading at a reasonable price? Unfortunately, in the age of near zero interest rates, these investments became as rare as non-tech unicorns. With that said, there is one area of the market where cheap compounders can be found in relative abundance allowing discerning investors to generate excess returns over time – Eastern European Banks.
Due to concerns about the impact of rising interest rates and other bank-specific events, a number of high quality financial institutions in the region have become much cheaper despite strong earnings growth and positive economic outlooks. At current prices, which are near the bottom of historical P/E and P/B ranges, the implied rate of return is 15-30%. Investing in banks can be frightening due to the leverage built into the business model, but the information below can help investors take advantage of this opportunity.
At Firebird Management, we have been investing in Eastern European banks for over twenty years with varying degrees of success. Despite a few setbacks, bank investments account for a significant portion of our long-term return and typically represent the largest sector exposure in our regional portfolios. The banks that turn out to be good investments generate value for years by compounding and reinvesting capital at attractive rates. We believe there are a few fundamental reasons for their success:
• Growth – Many of the Eastern European countries are structurally underbanked with banking assets to GDP well below Western European levels. It is not unusual to see loan growth of 10- 20% due to high single digit nominal GDP growth which is compounded by the narrowing of the banking asset gap relative to the developed world. For example, in the country of Georgia, loans to GDP rose from 20% in 2006 to 57% in 2017, at an average growth rate of 23%.
• Simple Business Models – Unlike Western institutions, high quality Eastern European banks generate earnings from simple lending and fee income, rather than derivative trading or excessive risk taking. They operate in an environment with net interest margins high enough to be the primary source of income, leading to double digit ROEs. In 2017, Russia’s largest bank, Sberbank, derived 71% of its revenues from net interest income. For JP Morgan, it was only 48%.
• Accommodative Competitive Landscape – Prior to 2008, investing in Eastern European banks was an almost certain source of profitable growth for Western European institutions. As a result of acquisitions, Scandinavian, Italian, and Austrian banks currently control as much as 90% market share in the Czech Republic, the Baltic states, and elsewhere in the region. The Global Financial Crisis of 2008 exposed issues in the domestic balance sheets of the parent banks which forced them to repatriate cash and leave their Eastern European subsidiaries to fend for themselves. Locally owned SME lenders like Banca Transilvania in Romania and Siauliu Bankas in Lithuania used this opportunity to grow into the void opened by foreign banks withdrawing from the market. Since 2015, Western European institutions have started cautiously growing their books, but loan approval powers remain at the head offices in Stockholm or Vienna, keeping the banks at a disadvantage to local players who can provide faster decisions and better customer service.
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