SCBPL: Cheapest Bank There Is?

Over the past few months, the banking sector has seen significant buying momentum. Of course, the banking sector is not alone in this as the pharmaceutical, fertilizer and oil & gas exploration sectors have also seen a notable re-rating. However, what makes the banking sector special is that it possesses the highest weight in the KSE100 index – comprising 25.85% of the index. Moreover, there are 15 banks included in the KSE100 index making it the most represented sector in the index.

As a result, it should come as no surprise that the index is up over 16% since the start of November and up nearly 35% since the start of September. Over that same time frame, the BKTI (an index representative of the banking sector) is up over 16% and 31%, respectively.

Of all the banks listed in the KSE100 index, only three banks have not been a party to this rally – Meezan Bank (MEBL), Faysal Bank (FABL) and Standard Chartered (SCBPL). FABL is down 5% since the start of September and November, while MEBL is down 1% and up 1% (respectively) over the same time frame. Their underperformance is understandable given that the SBP imposed a minimum deposit rate on Islamic deposits last month.

However, SCBPL is down 13% and 8% (respectively) since the start of September and November. And for no apparent reason. The only fundamental news which could’ve impacted its share price was the Q3 earnings which came in lower by 12.5% QoQ. Yet, this is not isolated to SCB as other banks reported similar earnings with HBL a 13% drop in profit QoQ too for Q3. And HBL’s share price has rallied 38% and 33% since September and November.

It can also be said that SCBPL missed a Q3 dividend but so what? Many companies have missed a dividend, and the market bats an eye for a while but then sees value and bids the share price up. A key example would be Airlink which skipped a dividend for Q3, but its share price has continued its ride upwards.

On a relative basis, SCBPL would be most comparable to MCB and UBL given the similar risk profile (low risk), growth rates, high dividend yield and high payout ratio of the three banks.

In the three graphs above, we see that there has been a divergence between UBL and MCB+SCBPL in the PE ratio and share price since September. In terms of dividend yield, SCB trades at a higher yield of 16% versus 13% for UBL and MCB.

Based upon this, it could be argued that UBL is expensive, however UBL has rallied very much in line with the broader banking sector and market. If anything, MCB and SCBPL would appear to be undervalued. Given SCBPL’s higher yield and its lacklustre price performance since September, it would make for a stronger investment case.

Naturally, when one finds such a case of undervaluation, you have to wonder: how did the share get to this place? And then one wonders: what will be the trigger to cause value realization? To answer the former question, SCBPL is relatively small bank in terms of deposits and assets, so it goes under the radar. In fact, it has a beta of 0.55 highlighting it tends to not be heavily correlated with the index and the need for triggers to realize value.

As for the latter question, the upcoming Q4 earnings season could be the important trigger which causes a re-rating of SCBPL especially since it skipped a dividend for Q3. Expectations of a higher year-end dividend could drive up SCBPL’s share price. Plus, the market might take notice anyways since the banking sector has received key attention. So much so that even smaller banks like Soneri Bank have rode the wave of optimism recently.

Furthermore, there have been rumours that SCBPL’s downsizing of traditional banking network (bank branches) is indicative that it is preparing for a delisting or exit from Pakistan. If these rumours re-appear, they could act as a strong trigger for value realization.

Finally, a key concern that investors have when analyzing SCBPL is that it trades at a relatively high price-to-book ratio. Yet, this is a non-concern because a high price-to-book ratio is a function of a higher ROE. This blog has discussed this linear relationship between P/B ratio and ROE previously. Consequently, SCBPL’s relatively high P/B ratio is well-justified.

A high-quality bank such as SCBPL probably shouldn’t trade this way (sideways). At least, historically it hasn’t for too long.

July-Aug Investment Thesis

SBP announced that it will hold its first monetary policy meeting for the second half of the year on the 29th of July. The market, in expectation of that meeting, will begin to price in rate cuts and once the rate cut (expected 150 bps cut) occurs, dividend-yielding stocks will rally due to yield compression.

Post SBP’s June 2023 monetary policy meeting where a 150-bps rate cut was announced, high dividend-yielding stocks – particularly banking stocks – rallied. One can refer to the BKTI index for a clear visualization of this.

UBL, BAFL and MCB gave returns in excess of 25% within a few days of the meeting. A clear trend was observed between the secondary market for bonds and the stock market. Bond yields fell sharply but the stock market priced in the yield compression with a considerable lag. This lag might be shorter this time around as there is greater confidence regarding the possibility of a solid rate cut given that SBP has already begun the rate cutting cycle.

As the above shows, bond yields fell sharply over the last week hinting that yield compression might be in play in the stock market very soon. High-yielding banks should be an investor’s go-to in this scenario. The stock market has shown a tendency to price in yield compression first followed the pricing in of growth following it. The recent rally in the EV-related stocks (auto assemblers and battery manufacturers) depicts this could adequately.

Pakistan's Debt Dynamics: Less External Debt, Please!

Every once in a while, an ‘expert’ will expound their belief in various news media that Pakistan’s debt, especially domestic debt, should be restructured. What’s the key evidence or theory backing their arguments? Nominal figures stating the government could save an X billion amount of dollars in debt servicing.

These flimsy arguments are comical, to say the least. Another frequently cited statistic is that each 100-bps cut in interest rates saves the Pakistani government an estimated Rs 250bn. The interpretation of these figures totally misses the mark and primarily suffer from money illusion. Debt and its servicing costs cannot and should not be seen in nominal terms, alone.

Firstly, debt only has to be restructured when the borrower is unable to fulfil its financial obligations. When a borrower faces difficulty in making debt payments, creditors give concessions entailing a change in the payment terms (reduction in interest rate or extension of maturity) or a write-down (partial waive off) on the principal. This is done to avoid a costly bankruptcy case in the event of a default.

When it comes to domestic debt, the government is not close to this scenario at all as the SBP provides adequate liquidity to meet the government’s borrowing needs. Moreover, commercial banks are happy to continue funding government borrowing.

The need for domestic debt restructuring only arises if banks (or other financial institutions) decide not to fund government borrowing which could only happen due to a crisis of confidence. Historically, there has never been domestic debt restructuring which is why that crisis of confidence has not arrived.

However, hypothetically, if the government were to restructure domestic debt today, a crisis of confidence could arise in a future high debt-to-GDP ratio scenario. Which is why talks of domestic debt restructuring must not be taken lightly.

But what about the factor that really matters? Debt dynamics of domestic and external debt work differently for several reasons.

The above equation shows the domestic debt dynamics. The change in domestic debt-to-GDP ratio depends on a few key variables – real interest rate, growth rate, and primary balance. If r > g, debt-to-GDP escalates. Meanwhile, if the primary balance is negative (i.e. a primary deficit), then the debt-to-GDP worsens too.

Historically, real interest rates have averaged out around 0.1%-2.7% (depending on the choice of time period), while long-run growth rate of the economy has been 4.7%. So, in Pakistan, g > r by far which is positive for domestic debt dynamics. Implicit in this is the fact that the government has deflated its domestic debt over time – r has been low due to high inflation and central bank non-independence. Meanwhile, primary balance has been -0.5% of GDP since 1992 – which is not a good thing (IMF).

However, when you run these figures together in the equation, the total impact on domestic debt-to-GDP ratio has been negative – meaning domestic debt is sustainable or falling (in real terms).

Among this, there is an assumption that government revenues grow at the rate of nominal growth rate of the economy. Even that assumption mostly holds as nominal growth rate has been 13% while tax revenues have grown 12% over the past decade, for instance.

When it comes to external debt, the situation becomes murkier. To pay off external debt, the government does not only require tax revenue but adequate foreign reserves. Moreover, exchange rate shocks can escalate external debt payments (in local currency terms).

In the above equation which shows external debt dynamics, pcb stands for primary current account balance, while △res stands for change in reserves. In Pakistan’s case, interest rate on foreign debt r* has been 3.6% historically – much higher than that on domestic debt. Furthermore, the particularly troubling part is that this is only brought down due to concessional multi or bilateral lending.

The interest rate on commercial borrowing and bonds are usually 5% or above even in supposedly good times. Moving on, primary current account balance has been -1.9% of GDP since 1980. Even if you take out the effect of change in reserves (which is likely negative), the impact on external debt-to-GDP turns out to be positive – meaning external debt is rising in real terms or unsustainable.

This is some simple arithmetic which tell the true story of Pakistan’s debt dynamics. This is why when the Pakistani government restructured its debt in the 1970s and early 2000s, only external debt was restructured and not domestic debt. The math and some history speak for itself.

Cement Cos: Who is Best Poised to Benefit from Rate Cuts?

Cyclicals on the PSX have been on a serious bull run this year. Certain sectors such as the auto and fertilizer sectors have been on fire. Why? Well, expectations of an interest rate cut are leading to the belief that demand in the economy will pick up. Cyclicals would be a natural beneficiary.

The cement sector is another cyclical sector which has been at the forefront of this rally. With capacity utilization expected to be at 57% for FY24 and more capacity coming online over the next year, cement companies could see significant growth if demand does rebound.

But which cement companies would be best suited to exploit this opportunity? Or which ones could outperform the pack?

The important thing to note about cement is that the product is quite identical in quality, regardless of the producer. Moreover, the price of cement varies only based on the location of each producer (transaction cost). So, the differentiation in cement producers comes down to the production cost of each producer and their capital structure (debt-equity mix).

As a consequence, the key determinant of a cement company’s market value should be their production capacity.

If the market is valuing the production capacity of one producer more than another, it may be due to certain idiosyncratic characteristics. For instance, Bestway Cement has better governance practices than its competitors, so it naturally trades at a premium. But on average, companies with a lower market cap per ton of production capacity should be seen as cheaper on a fundamental basis.

Similarly, those with a lower PEG than the average should be seen as attractive as an investor is able to purchase growth at a lower per unit price. For the same reasons, a lower-than-average price-to-book value and EV per EBITDA would be attractive. However, a lower EV per EBITDA is special for another reason too.

Enterprise value is simply the total value of the firm’s debt and equity. Once interest rates fall, value would be transferred from debtholders to equity owners as finance costs for a company would fall. Or in other words, income flow to debtholders would fall.

Thus, a lower EV per EBITDA implies that the market is pricing each rupee of enterprise value for each rupee of earnings at a low rate. When interest rates fall, that enterprise value would become more valuable for shareholders.

On the flip side, a better-than-average return on equity and assets would be preferred as it implies more efficient capital allocation.

These metrics have been calculated here for the cement sector. Based on these metrics, Maple Leaf Cement looks the cheapest. Other seemingly cheap companies appear to be Fauji, Attock, Cherat and Kohat Cement.

Lucky Cement also seems to look cheap, however one cannot treat it as a true cement company due to its diversified (conglomerate) nature.

Based on these calculations, personally I prefer Maple Leaf, Attock and Fauji Cement among these fundamentally cheap companies, as they have a lower-than-average market cap per ton of production capacity.

An alternative viewpoint could also be to consider debt-to-equity ratios and pick those companies with the highest debt-to-equity ratios. Why? Well, when interest rates fall, finance costs (interest expenses) for such companies would plummet allowing them to enhance their earnings.

However, I personally do not subscribe to this view as it seems to take on unnecessary risk. One must note that the cement companies with the highest debt-to-equity ratios are those who are loss-making. What does this say about the management of these firms? Plus, why take on needless interest rate risk?

Furthermore, EV per EBITDA as a metric already captures the element of falling interest rates buttressing the financial viability of a firm.

So, based on this, when can one expect some of these cement shares to catapult themselves to new heights? Well, that’s the catch; one needs to be patient. It was only last week that Gharibal Cement (GWLC) was looking most cheap on these metrics.

Yet, within a week the share price of the company has gone up 37%. Now suddenly, the company looks realistically priced on a relative basis. That’s the thing about markets. They ignore value for some time. And when they do notice value on the table, they do so with aggression.  

Why OMOs Don’t Always Cause Inflation

Many commentators have been touting the monetarist belief that increased money supply through SBP’s Open Market Operations (OMOs) will continue to stoke inflation. It’s a belief I’ve held too but it is not true as circumstances have changed.

Money supply has been rising steadily over the years with an uptick since 2021. Monetarists would tell you this has been the true cause of inflation in Pakistan while quoting Milton Friedman: “Inflation is always and everywhere a monetary phenomenon”. 

(Source: State Bank of Pakistan)

This belief stems from the fundamental monetarist equation MV=PY (where M stands for Money Supply, V for Velocity of Money, P for Price Level and Y for Real GDP). A monetarist will tell you that if you hold V and Y constant, the only cause of inflation would be money supply growth. Thus, curtailing money supply would curtail inflation. Meaning, money supply growth and inflation (price level growth) follow a one-to-one relationship.

Generally, this has been true as money supply (M2) growth has largely tracked inflation in Pakistan. However, there has been a differential between the two much of the time. This is because the monetarist assumption of Y (and V) being constant does not always hold. 

(Source: IMF) 

For instance, most of the 2000s and early 2010s were a period of positive supply shocks marked by low commodity prices, thus helping generate lower inflation than as predicted by M2 growth. But this can work in the opposite direction too as the severe import restrictions and commodity price shocks in 2008-2009 and 2022-2023 led to inflation spiking beyond M2 growth. 

Nonetheless, a general trend between money supply growth and inflation can be inferred. So even if we take the monetarist belief as the rule and these slight divergences as the exception, how does SBP create money? 

For one, SBP can circulate more notes and coins to increase money supply. This is generally done to meet demand for money. A standard example is that during Ramadan/Eid, money demand spikes so the SBP caters to this demand in order to keep interest rates the same. And also, to not curtail real activity in the economy. After all, money is there to facilitate real transactions.

But the more sophisticated approach to creating money involves open market operations. Outright open market operations generally entail the SBP buying or selling bonds to vary money supply. Generally-speaking, when SBP buys bonds, the money supply goes up as the public has more cash while SBP selling bonds does the reverse. Note, broad money supply is defined generally defined as currency in circulation plus short-term deposits (current and savings account for instance). 

 

The transaction involves SBP buying bonds from financial institutions and crediting the accounts of those institutions. Now, ideally banks would use that credit to lend it out to borrowers as they do under normal circumstances. Those borrowers would keep their loans in the bank (as deposits), thus creating money and having an impact on the real economy. Note, in this process, it is the banks that are actually creating money through their choice to lend or not although SBP began the initial process of credit. 

However, when economic conditions worsen, banks generally tend to lend to the government or simply hold excess reserves. So greater credit (monetary base) does not translate to greater money supply. Hence, understanding how government borrowing is facilitated and how that money is spent can help unravel inflationary trends. 

When the government is short of cash, SBP performs what is known as reverse repos (another kind of OMO). In a reverse repo, SBP will buy T-bills or PIBs from banks with the agreement to purchase it at a higher price at a future date. The difference between the future purchase price and current sale price is determined by the interest rate. Meanwhile, the future purchase date depends on the tenor set by the SBP which usually ranges from 7 to 28 days. 

Now, when the government needs cash, SBP will perform these reverse repos so that banks have more cash. So, when the SBP holds auctions for government securities (to raise cash for the government), the banks will fund it with the cash received from the reverse repo. This is the great monetary settlement between the SBP, the government and the commercial banks.

But hang on a second, how does this cause inflation or affect the real economy? Well, when the government receives that money from the auctions, it chooses to spend it on goods and services. So, let’s say the government buys wheat from flour mills for a new subsidy program. The flour mills receive that cash and choose to spend a portion of it (or hold a portion as deposits). That spending leads to an income for someone else and this cycle continues ad infinitum. 

This is precisely how SBP’s reverse repos lead to inflation. But implicit in this example is that the government is spending that cash on goods which affects the real economy. As in, it is running a primary deficit which it generally has for most recent years.

However, this financial year, the government is actually running a primary surplus. Meaning, it is not really spending that reserve repo cash on goods. So where is that cash going? Well, it’s not really going anywhere; it’s just being circled around.

Essentially, that cash is being spent on debt servicing. So, the SBP is still handing cash to the banks which are buying government securities at auctions and giving the government that cash but only to retire or service old debt. So really, the money is not being spent anywhere – not making its way into the real economy or increasing the number of deposits. 

In this scenario, OMOs really do not cause inflation. An interesting example or parallel in monetary history to this would be the German MEFO bills of the Nazi-era. 

During the Nazi-era, the German government needed a lot of cash to reinflate the economy. Naturally that would cause inflation, so Hjalmar Schadt (the German Central Bank President) introduced an ingenious security called MEFO bills.

MEFO bills were promissory notes that served as bills for payment by the German government to manufacturers. They were convertible to the German currency but a higher interest rate on them was offered to entice manufacturers to hold those notes. Meanwhile, the maturity on these notes would continually to be extended so as to avoid conversion of these notes to the currency – to avoid increasing money supply.

So, what’s the lesson here? Greater credit does not always mean greater money supply or inflation. Consequently, OMOs (credit creation) do not always cause inflation. At least, they are not causing inflation in the present circumstances.