/ 20 July 2006

Local banks are cheap

Company earnings on the local market are very strong at the moment, but probably have already reached their peak in percentage gains terms.

Sometimes (about 25% of the time) all investment markets behave irrationally. While we do not believe that the overall market is irrational (that is, commodity shares are overvalued and should fall), the market is currently punishing the shares that are actually cheap.

The local banking shares are a prime example, but basically most, if not all, purely South African shares are the same. These shares may fall further in the short term, but they truly represent absolute value at the current level.

An example will illustrate this. The ultimate “free lunch” in investment terms is a “self-funding” investment. This is an investment that generates a positive cash flow versus the cost of the investment — cash in the bank.

These “free lunch” investments means that, because they finance themselves (a positive cash flow), you as an investor can hold them indefinitely. You don’t even have to worry about the capital price; you can wait forever for the capital price to recover from a fall. So, this is the investment El Dorado.

The outlook for banks earnings is still very good for this year. The earnings are in the bag. However, with higher interest rates, next year will not be as good. But this is not a disaster scenario; it is simply a return to a more normal earnings pattern. Banks earnings are not about to disappear.

Take Absa as an example. The current dividend (historic) is 4% and Absa has had a dividend growth rate of 17% on average for the past 20 years. This period includes the Unifer debacle (I am sure it is still called Lucifer at Absa), as well as a few strong growth periods.

While I have no idea what the dividend growth will be over the next 20 years, a 10% growth rate is a conservative estimate.

Now, where is this free lunch?

If investors have cash in the bank at the moment, they earn about 4,2% after tax. Let’s estimate that this will increase to 5% aver the next five years (an average gross yield of 8,3%). So, a free lunch will be when the dividend yield (the actual dividend you receive going forward, based on the current price of the share, all tax free) exceeds the after-tax interest rate.

In this scenario you would not worry about having bought the share with money you had in the bank, as the dividend you receive would be the same and would even grow.

Therefore, assuming a 10% dividend growth rate, you eat for free in just more than two years and thereafter you can keep this investment forever and never worry about a fall in capital value. You can wait “forever” for the price to recover to a good level. In other words, you will be in the same position cash-flow-wise in two years’ time as if you had cash in the bank — maybe even better, because dividends grow over time.

Quite frankly, this is about as good as it ever gets in investments.

Now, just to make sure that investors clearly understand what I have said: banking shares are dirt cheap. But this does not mean that the price is not going to fall in the short term. Sentiment is against all shares at the moment.

If this happens, then they just become cheaper. Also, don’t put all your money into Absa. This was just an example. Buy a spread of the big banks, go into a banking-oriented unit trust, or buy a diversified portfolio of South African shares.

Wayne McCurrie is deputy MD of Advantage Asset Manager