PORTFOLIO STRATEGY - Appreciating Banks

TENS OF BILLIONS OF dollars in losses from subprime exposures and a $7 billion hit from a rogue trader at Société Générale have shattered investor confidence in many big banks. But amid such troubles many investors continue to see good value in emerging-markets lenders.

“It’s ironic that the issues that used to make investors uneasy about emerging markets — lack of transparency and fear about unknown exposure — are the same ones that are driving investors away from large Western banks,” observes Harold Sharon, director of international equities at Lord, Abbett & Co. He believes select emerging-markets banks have become safe havens because they are proxies for strong regional growth.

Industry data certainly supports that view. In the 12 months ended February 29, the FTSE index of 168 banks in developed markets had fallen by 18.9 percent in dollar terms, while the comparable index of 104 emerging-markets banks had risen by 15.8 percent.

Mark Edwards, co–portfolio manager of the $4.3 billion T. Rowe Price Emerging Markets Stock fund, thinks these banks are a good way to play the world’s fast-growing emerging-markets economies. Consumer demand is growing rapidly in these countries, and it is increasingly fueled by credit, he notes. In addition, “much of the emerging banking industry is modernizing, growing more efficient as firms are weaned off their government-owned models and transformed into private commercial enterprises,” he says.

So compelling are these trends that banks represent 18 percent of Edwards’s portfolio, compared with a 15.1 percent weighting in the MSCI emerging markets benchmark. That exposure has helped him significantly outperform the MSCI EM index. Through February 28 his trailing 12-month total return was 39.45 percent, besting the benchmark by 634 basis points. His five-year annualized return was over 38 percent, outperforming the index by 490 basis points.

Five of Edwards’s top 25 holdings are banks. His third-largest position is Brazil’s Banco Itaú Holding Financeira. The fund has slightly more than 2 percent of its assets in Itaú, a position it has built up since January 2001 at an average price of $4.93 a share. That investment is up more than fivefold, with the stock at $26.44 in late February.

“Supported by a domestic economy that’s been growing at 3.5 percent a year, Itaú is one of our favorite emerging-markets plays, enjoying steady loan expansion, solid asset quality and improving cost control,” says Edwards. Those factors have produced average earnings-per-share growth of 25 percent over the past three years.

Edwards expects profit expansion to slow to 14 percent by 2009 as the bank continues to shift its assets from high-yielding government bonds to less-rich consumer and corporate lending, and as competition from other lenders intensifies. But the fund manager sees top-line growth continuing to benefit from increasing consumer and corporate loan penetration. Brazil’s loan-to-GDP ratio rose from 24 percent in 2004 to 35 percent in 2007.

Edwards also likes Middle Eastern banks; 1.7 percent of his portfolio is invested in Commercial Bank of Qatar, and 1.4 percent is in Oman’s BankMuscat. The setback in Gulf equity markets last year, which saw regional indexes lose as much as half of their value, has made these markets more attractive, he adds. “With oil bumping up and over $100 a barrel, infrastructure booming and consumerism on the rise, we believe local banks are well positioned to benefit,” he says.

Lord Abbett’s Sharon likes emerging-markets banks in Asia. The firm’s $1.6 billion International Core Equity fund has 1.5 percent of its money in Kookmin Bank and Pusan Bank of South Korea. Pusan’s loan growth accelerated to 25 percent in 2007 from 20 percent in 2006, while net interest margins have been steady at about 3 percent. With Pusan selling at a 1.7 price-to-book-value ratio, compared with a median of 2.7 for the FTSE’s emerging-markets banks, Sharon sees the potential for rerating.

Rich valuations have caused some fund managers to cut back on emerging-markets banks, though.

Julian Thompson, co–portfolio manager of the $659 million RiverSource Emerging Markets fund, has steadily reduced his banking exposure from an above-market weighting of nearly 17 percent at the beginning of 2006 to 8.4 percent last month. With interest rates tending to decline in most markets, and banks shifting assets from low-risk government bonds to consumer lending, Thompson worries that banks will “take on more risk at lower net interest margins.” Still, he remains sold on the merits of Russia’s $85 billion-in-assets Sberbank — his sixth-largest holding, representing 2.9 percent of the fund. The state-controlled giant dominates the country, with 11,000 branches (its closest rival has 500) and market shares of 37 and 32 percent, respectively, in retail and corporate lending.

Sberbank has been boosting annual earnings 30 percent-plus over the past three years, and Thompson projects 33 percent growth in 2007 (which the bank has yet to report) and 2008. His average cost per share is about $2, and the stock was trading in Moscow in late February at about $3.33.