Bank shares: To buy or not to buy

Major Banks downgraded

Following on from South Africa’s ratings downgrade on Friday (27 March) to sub-investment grade (junk), by Moody’s Investor Relations, it comes as little surprise that Moody’s has now also downgraded the long-term local currency and foreign currency deposit ratings of South African banks, ABSA, FirstRand, Nedbank, Investec and Standard Bank to sub-investment grade as well.

The ratings agency cited the following as primary reasons for the downgrade:

The negative outlook of the South African banks' ratings reflects our expectation that the weak economic the weak economic environment will increase the downside risks for bank’s credit profiles. The challenging operating environment will translate to higher impairments for the banks; exerting negative pressure on revenues and testing the resilient performance they have demonstrated in recent years. However, Moody's does not anticipate that the asset quality deterioration will materially compromise banks’ capitalisation. The negative outlook on the bank is aligned with the outlook on the sovereign rating, which reflects downside risks around economic growth and fiscal metrics, that could lead to an even more rapid and sizeable increase in the debt burden, further lowering debt affordability and potentially weakening South Africa’s access to funding.’

Moody’s was not the only ratings agency to downgrade the domestic banks. Fitch Solutions also lowered its already sub-investment grade rating on the banks one notch further as well.

Covid-19

Before the disruption to business had been incurred by COVID-19, recent results from major South African banks have shown a trend of rising defaults and higher credit loss ratios in both the personal and business banking divisions. Earnings from banks (in latest reports) have ranged from single digit contraction to low single digit growth.

While bank earnings are closely tied to economic health, the current economic recession and ongoing COVID-19 pandemic are painting a stagnant outlook. Lower interest rates will compress margins for these companies while relief efforts will stifle earnings. Credit impairments from both personal and corporate banking is expected to rise further amidst the current disruption, the length of which remains uncertain.

Is the risk priced in?

South African banks have had a torrid year. A weak economy furthered by the COVID-19 pandemic is likely to see a furthering of credit losses for these banks. Relief initiatives combined with lower interest rates will see a contraction in earnings and margins.

However, ABSA, Nedbank, FirstRand, and Standard Bank remain well capitalised and highly liquid. Current valuations for these companies are at significant discounts to historical means. While the earnings outlook has blurred the extent of decline in 2020, there does now appear to be a significant amount of risk priced into the sector. As the disruption from COVID-19 starts to turn the corner we do expect to see these companies rerate to trade well off the near-term lows.

While short-term volatility is likely to remain, a far-sighted investor may consider current levels a good start for a longer-term accumulation.

Year to date performance

The above graph shows the share price performances of these banks for the year to date. The dramatic sell-off we have seen has brought these counters to levels not realized in years. In some cases more than a decade.

FirstRand Ltd would appear the relative outperformer, having declined less than its peers. Nedbank Ltd is the worst performing of the banks having seen its share price decline the most year to date.

Broker Ratings

The above table highlights a collated analyst ratings data sourced from Thomson Reuters. Standard Bank and Absa Ltd both have an average long-term rating of ‘Buy’, while FirstRand and Nedbank both carry an average long-term rating of Hold.

Traders view

In the short-term volatility is likely to remain in the banking sector. The underlying trends remain down, although traders might be wary of a short-term capitulation in weakness and possible rebound.

We feel that the extent of the decline makes it difficult to short the sector at current levels. Traders might prefer waiting to re-enter short on a rebound rather than at current levels. Alternatively, traders may look for some positive signs of a price reversal to renew long positions. Should any of these opportunities emerge we will update accordingly on the IG trading platform.

For now we prefer a market neutral trading strategy within the sector as outlined below.

Standard Bank vs Firstrand Ltd

The chart considered is that of Standard Bank (candlestick) with a Relative Strength Comparison (RSC) indicator added (Blue Line). The RSC (blue line) compares the price of one security with that of another in a ratio format. The RSC has experienced a decline in value recently which highlights that security 1 (Standard Bank) has been underperforming security 2 (FirstRand). A Bollinger Band channel has been added to the RSC and highlights the short-term underperformance of security 1 against security 2, shares which have otherwise had a high degree of correlation in the near term. It is expected that the relationship between the two securities will revert to normality favouring a possible pair trading opportunity i.e. Long Standard Bank, Short FirstRand. The target from the technical indications would be for the RSC to move back towards the ‘Mean’ (moving average red line). This could occur with the price movements of the securities in several ways;

1. Standard Bank rising and FirstRand falling
2. Standard Bank rising faster FirstRand rising
3. Standard Bank falling slower than FirstRand falling

Should one of these scenarios play out, the expectation would be for a net gain of 4%. A stop-loss is considered should the net loss of the two positions amount to 4%.

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