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Stark contrasts in Eastern European banks A series of insights by our portfolio managers from the road

By Archie Hart Portfolio Manager: Emerging Markets Equity, February 2014

Archie Hart I have spent 25 years researching and investing in emerging market companies, 12 years of them in Hong Kong. I was in Asia during the Asian Financial Crisis of 1997/98, which was a formative experience. That experience continues to provide vital context and perspective, particularly in today’s environment. A recent visit to Eastern Europe — Turkey, Hungary and Poland – served to illustrate the variety and diversity in emerging markets as an asset class. Certainly our progression from sunny Istanbul to snow and subzero temperatures in Warsaw was one aspect of the trip. But also the contrast between Turkey in crisis with its economy slowing, Hungary recovering from a deep recession, and Poland exhibiting steady growth was also stark. The major focus of the trip was visiting banks in all three countries, which caused us to muse on the difficulties of analysing these types of companies in particular.

The major focus of the trip was visiting banks in all three countries

Financial district of Istanbul

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Our 4Factor process is a combination of an objective stock screen (directing our analysts to a high-scoring subset of ‘good ideas’), from which our rigorous fundamental research process selects the strongest or best ideas for our portfolios, all bounded by a coherent and strong risk process. The trip amply illustrated some of the insights that can be gleaned when you think about the world using our framework.

The trip amply illustrated some of the insights that can be gleaned when you think about the world using our 4Factor framework


Turkey After 25 years in emerging markets it has become clear to me that one of the chief weapons of an analyst in emerging markets has to be a deep sense of context and perspective. Without it you are left open to being buffeted by the extreme volatility that is part and parcel of investing in emerging markets. Turkey is a classic example of just such volatility as we speak. On 17 December 2013 a major political crisis erupted in Turkey. In brief, a schism suddenly opened up between former allies: the ruling AK party and the ‘Gulenists’ movement (which is deeply embedded in the Turkish state, with millions of followers) led by Muhammed Fethullah Gulen, a Turkish Imam now

resident in Pennsylvania, in the United States. If this sounds faintly surreal, that is because it is. However, the consequences have been profound, with the disclosure of wire-taps, police raids, allegations of corruption at very high levels of government, arrests, detentions, turmoil in the police and judiciary etc. An in-depth discussion of these events lies outside the scope of this note; however, they have significantly impacted both the value of the Turkish lire, and the Turkish stock market. Concerns have been heightened over the impact this political instability might have on the Turkish economy. These economic concerns have been amplified due to the fact that Turkey is one of the emerging economies with a high current account deficit and thus reliant on foreign investors to finance its growth. Any increased caution by

POST CARD Spent trip visiting banks in Turkey, Hungary and Poland Turkey • Interesting time to meet Turkish banks, as their share prices fell by 31%-46% in 2013 • Buying Turkish banks now is akin to trying to catch the proverbial falling knife Hungary • Hungary is just emerging from recession, with a banking system that is in very poor shape

• Hungary is a difficult place to invest, but bank valuations are clearly cheap Poland • Polish banking sector is relatively fragmented, highly competitive • Success in Poland is about incrementally increasing market share, controlling costs, improving returns Some interesting opportunities but selectivity will be key


Istanbul Sapphire, the tallest building in Istanbul and Turkey

Stark contrasts in Eastern European banks (continued)

investors would imply Turkey would only be able to secure financing on more onerous terms, thus threatening future economic growth.

Are Turkey’s institutions sufficiently robust to withstand the current turmoil without becoming irrevocably impaired? For us, however, we believe there is little to be usefully gained by becoming mired in deep political analysis of Turkey. Those who have studied the subject for many years did not forecast the events of 17 December (and subsequently) and thus we should be cautious about reading too much significance into their analysis. The central question, as one of the bankers we met put it to us, is: are Turkey’s institutions sufficiently robust to withstand the current turmoil without becoming irrevocably impaired? So far, we believe, Turkey’s institutions have been put under great stress, but we don’t currently see any descent into chaos as being likely. Furthermore, for all the hysteria currently surrounding Turkey’s economy and politics we believe two numbers are worth noting. In the 45 years from 1967 to 2012 Turkey grew its real GDP, in US dollar terms, at a CAGR of 4.3%. In the 10 years to 2012 it has grown its real GDP, again in US dollar terms, by a CAGR of nearly 5%. Turkey has in no sense been a ‘basket case’ in the

past, and we see no reason why it should be in the future. In the last 10 years the Turkish stock market index, in US dollar terms, has returned 164% (period ending 31 December 2013). This return lags that of emerging markets as a whole (198%), but is substantially in excess of the return from developed markets during that period of 110%. Whilst in Turkey we met the management of eight banks. Of the seven that were investable, their share prices had fallen by between 31% and 46% in US dollar terms during 2013. It was an interesting time to meet them, but I was constantly reminded why we believe meeting management is a useful adjunct to a fundamental research process, but shouldn’t be central to it.

Turkey has in no sense been a ‘basket case’ in the past, and we see no reason why it should be in the future The meetings had a distinct pattern. Often management would start the meeting with phrases such as, “it is a difficult time to give point estimates” or “we have to use a pencil for our budget”. Then they would proceed to give us detailed forecasts for the year ahead. In other words, having talked about the extreme difficulty of forecasting…. they then made forecasts. For us that is an indication that management is clearly overconfident in its ability to forecast


in a period of high uncertainty. Furthermore, forecasts seem to be for a gentle slowing from 2013 growth rates. This may be correct, but forecasts seemed to be anchored to previous growth rates, rather than any particularly strong view of the future. Lastly, there was a strikingly uniform view of the future – forecasters were effectively herding together around a consensual view of the future. Overconfidence, anchoring and herding are all common behavioural errors that forecasters make. In that sense Turkish bankers seemed to exhibit similar behavioural traits to many investors. A further difficulty with all banks (not just Turkish ones) is that they are generally very difficult to analyse. That is because they are essentially ‘black boxes’. How can one really know which banks have more conservative lending policies, or which are more reckless, until the loan books are stressed by a recession. How do banks really run their treasury operations? The global financial crisis starkly illustrated how little an external party can really know about the internal workings of a bank. Fortunately, our financials analysts are probably our most experienced sector team. That experience has proved invaluable in regard to Turkish banks.

Turkish banks have been a major topic of internal discussion for us throughout most of 2013

Turkish banks have been a major topic of internal discussion for us throughout most of 2013, with our screen flagging them a number of times as potentially good ideas. Despite this ongoing internal debate, we remained underweight in Turkey throughout 2013 in our emerging market portfolios, and did not own any Turkish banks in 2013. The reason for this caution is a number of concerns held by our banking analysts. Firstly, the Turkish central bank chose to fund its banking system using two interest rates, effectively an interest rate corridor. The central bank could then choose to lend at either the lower or the higher rate depending on whether it wanted to inject or reduce liquidity in the system. For an analyst this creates the not insignificant problem that funding costs for the banking system become opaque, and thus the level of net interest margins (a major component of almost all banks’ revenues) going forward becomes highly uncertain. A second issue our analysts grappled with was high loan growth in Turkey (29% CAGR from 2007 to 2012 in the seven banks). In that period loan books grew just under 180% versus loan loss reserves up less than 60% in that period. Were the banks reserving enough? Particularly given that high loan growth often leads to credit problems down the road. Furthermore, our valuation work led us to the conclusion that valuations did not sufficiently discount the uncertainty that we saw.

The Maiden’s Tower (Turkish: Kız Kulesi), also known as Leander’s Tower


Stark contrasts in Eastern European banks (continued)

Despite this ongoing internal debate, we remained underweight in Turkey throughout 2013 in our emerging market portfolios, and did not own any Turkish banks in 2013 Overall, our analysts came to the view that masterful inactivity was the right course of action in 2013 with regard to Turkish banks. This turned out be correct, although of course we could not have forecast the eventual out turn with any degree of accuracy. However, that was then, this is now. What should we do now? Here we come to an interesting process issue. In general six of the seven banks all score reasonably well with regard to Earnings, Strategy and Value. But they are all without exception low-scoring on Technicals (all at the lowest score possible). We believe that share prices contain information, and that share price trends can persist for some time. Buying these beaten down stocks before their share prices recover is to some extent going against some of the core tenets of our investment philosophy (other people might use the phrase that buying Turkish banks now is akin to trying to catch the proverbial falling knife). That should – and does – give us pause for thought.

Budapest

Buying Turkish banks now is akin to trying to catch the proverbial falling knife

Hungary Hungary is a very different story to Turkey – a recovery story versus Turkey’s dynamic, but slowing, growth story. Hungary is just emerging from a significant recession, with a banking system that is in very poor shape. As a result, the issues facing an investor in Hungary are quite different to those facing an investor in Turkey. One interesting conversation topic whilst we were in Hungary was around speculation that one western bank in Hungary had offered its bank for sale for the princely sum of one euro…and found no takers. That is a clear indication of the continuing major contentious issues around the Hungarian economy and banking system.

Hungary is just emerging from a significant recession, with a banking system that is in very poor shape The core weakness of the Hungarian banking system was an orgy of Swiss franc (and to a lesser extent euro) lending for Hungarians to buy their homes in the Noughties. The stupidity of both the lenders


and borrowers became obvious as the global financial crisis broke in 2008. Most of the loans were made at an exchange rate of c.160 Hungarian forint to the Swiss franc, vs. today’s exchange rate of c.250. The damage was exacerbated by a fall in Hungary’s GDP of nearly 7% in the global financial crisis, leaving borrowers poorly placed to meet higher repayments. One startling statistic is that there were only 7,100 new housing construction permits in Hungary in the first nine months of 2013, on an annualised basis that is less than one-fifth of the total in 2004 (47,400). I personally have always abhorred foreign currency lending to domestic borrowers. It is a little like giving a loaded gun to a child. If it all goes wrong — as it probably will — you only have yourself to blame. My dislike of this banking practice derives from my time in Asia during the 1997/98 financial crisis when it became very evident the enormous damage such lending practices can wreak on the banking system, stock market, economy and — most importantly of all — people of a country. A few years ago, I asked a Hungarian banker why his bank had lent so heavily in Swiss francs to borrowers with only forint incomes and forint assets. His reply was that if they hadn’t they would have lost significant market share. And anyway, everybody else was doing it. I realised that I had effectively asked a lemming why he

had jumped over a cliff. It’s a silly question. Lemmings jump over cliffs because they are lemmings. However, after five years of dealing with the aftermath of the Swiss franc lending binge, whilst also facing very aggressive and unorthodox policies towards the banking sector by the government, it is clear that the economy and banking system of Hungary is bottoming out. The economy is growing again, unemployment appears to have peaked, the trade and current account balances are now positive, and the economy has significantly deleveraged. Hungary is a difficult place to invest, but bank valuations are clearly cheap, reflecting concerns around the risks both of the economy and specific to the banks. However, those risks have now reduced (CDS spreads have narrowed further in Hungary than in any other major emerging market country in the past year). At the point where major banks cannot even give their businesses away, this seems like a country tailor-made for contrarian investors.

At the point where major banks cannot even give their businesses away, this seems like a country tailor-made for contrarian investors Market Hall, Budapest


Stark contrasts in Eastern European banks (continued)

Poland Compared to the growth and volatility of Turkey, and the risky recovery story which is Hungary, Poland is…. well….just ever so slightly dull. Not that this is at all a negative thing given the volatility exhibited by many emerging markets in recent months. Poland’s economy stands out in that it continued to grow throughout the global financial crisis, recording growth in every quarter. Its banking system also failed to get as deep into the foreign currency lending debacle as many other Eastern European banking systems. Partly this was due to a slightly more proactive regulator, and partly due to slightly more conservative bankers and borrowers. And possibly they were just lucky.

Poland’s economy stands out in that it continued to grow throughout the global financial crisis The Polish banks are interesting in that they are varied with some quite different strategies: locally owned, foreign owned, consumer focused, mobile and internet focused, corporate focused, high growth, more conservative, possible acquirers of other banks, possible sellers etc. Controlling shareholders of the listed banks are diverse; including Polish, Spanish, Italian, Portuguese, German and American banks. For a stockpicker this diversity is a positive.

Furthermore, the environment of stable growth means that the potential investment cases for these banks are extremely operationally focused; in short, it is all about execution. The Polish banking sector is showing only moderate growth, is highly competitive, relatively fragmented and has a regulator that is active (don’t misunderstand us here; an active regulator is a positive. We all now know what an inactive banking regulator means long term for the health of a banking system). Success here is about incrementally increasing market share, controlling costs, improving returns — all at the margin. For us this means assessing evidence about whether a management team is executing successfully, or not. We found clear evidence of both types of management. That is important, as the investment business is about both what we choose to own, and also what we choose not to own. Finding banks that are not (in our view) executing is in some ways as valuable as identifying those that are. The other interesting aspect of Poland was an economy that was, the bankers told us, beginning to pick-up pace. After a dull H1 2013, the economy began to improve in H2 2013 and most bankers seemed to expect 2014 to be incrementally better than 2013. There was, in other words, some potential for a positive surprise against expectations that seem only moderate.


Potential investment cases for these banks are extremely operationally focused; in short, it is all about execution It is important to be aware, however, that the major driver of the Polish stock market in 2014 is likely to be government policy, and have very little to do with how the economy performs. The issue is a major change being proposed to the Polish pension system. The Polish government plans to strip holdings of Polish government bonds from the private pension system (over 50% of assets in the system) and cancel them immediately, in return for paying pensions when they become due. Participants in the private pension system will be given a period of time to decide whether they remain in the private pension system or switch into the public pension system. Lastly, the private pension funds will initially, post the implementation of this policy, have 100% of their assets in equities.

Finding banks that are not (in our view) executing is in some ways as valuable as identifying those that are The importance of these moves is that the Polish stock market trades at a premium at least due to Poland’s strong pension fund system, which

funnels liquidity into the market. Post these changes – which amount to a significant reduction in the size and scope of Poland’s private pension system — it is clear that pension fund inflows into the market will be — at best — significantly reduced. This could endanger the premium that the Polish market trades on. It is quite possible that the Polish stock market in 2014 will be driven by these pension fund changes, rather than Polish corporate fundamentals or the country’s economy. Again, this is an interesting challenge for an analyst; sometimes corporate performance can diverge from stock market performance for some time. The fundamentals of Poland are strong, but in the short term this may not impact stock market performance too much.

It is quite possible that the Polish stock market in 2014 will be driven by pension fund changes, rather than corporate fundamentals or the country’s economy


Important information This document is not for general public distribution. If you are a private investor and receive it as part of a general circulation, please contact us. The information discusses general market activity or industry trends and should not be construed as investment advice. The economic and market forecasts presented herein reflect our judgment as at the date shown and are subject to change without notice. These forecasts will be affected by changes in interest rates, general market conditions and other political, social and economic developments. There can be no assurance that these forecasts will be achieved. Past performance should not be taken as a guide to the future and there is no guarantee that this investment will make profits; losses may be made. The information contained in this document is provided in good faith and has been obtained from sources believed to be reliable. No warranty is provided as to its accuracy or completeness. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale and is not a buy, sell or hold recommendation for any particular investment. In the U.S., this communication should only be read by institutional investors, professional financial advisers and, at their exclusive discretion, their eligible clients, but must not be distributed to U.S. persons. In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001). Outside the U.S., telephone calls may be recorded for training and quality assurance purposes. Issued by Investec Asset Management Limited, February 2014.

Warsaw, Poland


Investec notes from the road archie hart in eastern europe feb 14