Presents for the Grandkids, Christmas 2050: an Explanation
Updated: Aug 6, 2019
Some notes so that their parents can try and explain what the heck Grandpa was thinking...
If I told you there was a bank that was trading for 4 times earnings, a fraction over the book value of equity and with a dividend yield of 9%, with a return on assets of 5% and a return on equity of 30%, would you believe me?
Surely you would ask: 'what is wrong with it'? It has enormous bad loans on its books that have not been provided for!'
No, asset quality is reasonable, about average for history, provisioned conservatively, and likely to improve going forward.
'It doesn’t have sufficient capital and must come to market and sell new shares at a low price and thus dilute shareholders?'
No, tier 1 common equity is over 20% and 5 percentage points above the regulatory minimum. And the bank has made the transition to IFRS 9 (CECL under US GAAP) whereby future expected credit losses are provisioned up-front, thus capital has already been reduced by the transition.
'Management are crooks then? They are dishonest, make up the books, write terrible loans, or have a history of poor capital allocation or treating minority shareholders poorly?'
Not true either. It is the most well managed bank, possibly most well-managed company, in the entire country. Its financials are audited not just once, but twice per year. In the ten years I have followed them not only have they been the smartest management team in the country, but they have conducted themselves with the utmost integrity.
'Surely then the entire country or market then is experiencing or about to experience an unprecedented crisis or massive currency devaluation? Or it is a sanctioned country like Iran or North Korea?'
Well, macro is hard to predict but the country has already effectively suffered a recession and has returned to modest growth, albeit below potential. The currency has fallen, it could decline further, but some of that will be offset by FX-related gains on the bank's balance sheet. Longer-term the economy should benefit from a labor force growing 5% p.a., low debt levels and banking sector penetration is low.
'OK, so what it is?!!?'
That’s what explains it. The bank is in Nigeria. And right now Nigeria sucks. It sucks because of US shale, which has turned the United States into the world’s largest oil producer and driven oil prices down to the mid-$60’s (Brent), with OPEC and Russia unable to do a thing about it.
While Nigeria’s economy is about much more than oil, it produces around 2mm barrels per day and oil makes up around 90% of exports and foreign exchange earnings. So when the price of oil collapsed from over $100/bbl in 2014 to $30/bbl in 2015, the country suffered a massive terms of trade shock, put enormous pressure on the currency, and has been dealing with the consequences ever since.
That is largely in the past. The only lingering question is whether the currency has adequately adjusted to the shock given that President Buhari and his central bank governor have fought tooth and nail to avoid a currency collapse. They have succeeded on paper, with the official rate held at 306 to the dollar, but at the cost of massively restricting capital and trade flows and inflicting a recession on the country. These unorthodox measures have merely delayed recognition of the underlying reality, but what is also true is that monetary policy has been kept relatively tight, and inflation of around 11% is starting to ebb (it has rarely been less than high single digits for the past twenty years in any case). The current central bank monetary policy rate is 13.5%, which is a real yield of over 2% and perhaps more if declining core inflation of 9% is a guide. So there has been orthodox monetary policy in response to the oil/currency/inflation trilemma as well.
Tellingly, the parallel, or black market rate of 360 to the dollar has been stable for quite some time. If we look at the relative pricing of US dollar priced GDRs and local shares in Naira, the market currently implies a similar rate. This rate could still be overly optimistic, but it is a significant indicator.
The oil price collapse and restrictions on capital flows and imports inflicted a nasty recession on the country. Bear in mind that the country’s demographic story continues to play out, with a population that is growing roughly 2.5% per year. The population is now around 190 m people. When I first starting looking at Nigeria around a decade ago the population was said to be 160m. That 30m increase in population is greater in absolute terms than the increase in the US population over the same period, a country that was almost exactly double Nigeria’s population ten years ago. The net increase in under a decade is greater than Australia’s total population of 25m.
The working age population is growing even faster. Over the three years from July 2015 to July 2018, the labor force increased 22%, or by 16m people to 90m, according to data from CEIC.
But despite this incredible growth in labor and an incredibly low per capita GDP of around $2,000, between 2016 and 2018 the economy only grew by 1% in real terms. The economy slowed significantly in 2015 to 2.65% and declined outright in 2016 by -1.62% and grew only marginally by 0.8% in 2017. In per capita terms this was a very deep recession, a decline of nearly 6% over three years.
That’s the background and the macro. But recessions don’t last forever. The oil price has recovered and at $65/bbl is at a reasonable level and Nigeria doesn’t need a high oil price to grow. In fact, it would be better for the development of the country if it became less reliant on oil.
The bank in question is Guaranty Trust Bank. It is the best bank in the country.
At its core, Guaranty’s Nigerian banking franchise enables it to attract a cheap deposits, roughly $6bn of them, at a cost of between 2-3%, and redeploy those funds at a rate of between 13-14% both in loans and also into low-risk government securities. Treasury bills and bonds also typically have yields in the double digits given the level of inflation. Moreover interest on government bonds are tax exempt, at least for now.
Essentially it is able to borrow at a cost well below inflation, and lend at rates modestly higher than inflation. The raw spread between its cost of funding and interest earnings on loans and securities comes to around 7-8%, or a net interest margin of over 8%.
Secondarily, as a key player in the Nigerian financial system Guaranty is able to generate a stream of earnings from fees and commissions. These fees range from foreign exchange commissions, account keeping fees, income from guarantees and a host of other charges. In addition, the bank has historically generated strong trading related and ‘other’ income, the latter typically born of translation gains on USD loans as the local Naira currency has depreciated. Expressed in a similar fashion to net interest margins, non-interest revenue typically adds between 2-4% in extra ‘yield’ on its interest earning assets.
In effect, the bank is able to generate overall income of between 9-12% on its deployed balance sheet, before taking into account loan loss provision, operating costs and tax.
Credit risk in Nigeria is high given the macroeconomic volatility, incidence of fraud and corruption, and the relative lack of large scale institutional borrowers. Lending to retail is very challenging and continues to be a work in progress. But Guaranty has continually demonstrated an ability to maintain decent asset quality and keep provision expenses contained.
As we glance down the income statement lines something else also stands out. Guaranty’s cost to income ratio is typically somewhere between 37-39%, an efficient ratio of operating costs to income given the environment (recall that operating a branch network in Nigeria has a lot of additional cost lines for things like fuel for generators and security costs). Guaranty has typically been able to keep operating cost growth down, and often well below inflation – frankly, maybe they’re even too good at this as below inflation increases in wages and salaries imply either redundancies or declining real income. This has to be demoralizing.
After taxes the bank is earning a return of a little over 5% on assets, even with a signifiant amount of liquidity kept at the central bank. With modest leverage of 6:1, the return on equity is around 30%.
But let’s be honest, if you have the branches and the brand, any banker in Nigeria can attract the cheap deposits, buy bonds and earn that juicy spread. For half the balance sheet it doesn’t even require the skills to write a good loan! Yet no other bank in the country has the reputation and track record of avoiding the big mistakes, the big bad loans, and generating the consistently strong returns that Guaranty has maintained over many years. What makes Guaranty different?
It comes down to leadership. Guaranty’s management is the best in the business. And in the banking business where banking services are largely a commodity (money is money), the people running it matter a lot. Probably more than in other industries. Guaranty’s management think carefully and conservatively about credit risk, about the allocation and husbanding of shareholders' capital and they treat all their stakeholders fairly and with respect. And somehow, I’m not sure how entirely, they have retained the ability to think for themselves and avoid the ‘institutional imperative’ to do what everyone else is doing.
We own shares in Guaranty. Given the current share price, the fact that management has proactively taken provisions as part of IFRS 9 implementation, and that Nigeria is slowly emerging from recession, we will probably buy a little more.
My grandkids will be getting some Guaranty shares in their stockings circa 2050. Hence the explanation.