Financials are cheap: Do you buy?

Durban - Financial shares moved up encouragingly on the JSE on Wednesday. But it looks like the share prices of banks and insurers were buoyed by positive news from overseas, where in the US more emergency lending was promised to banks caught in the credit squeeze.
European markets also took a more favourable view on banks, and the sentiment spread to the local stock exchange.

It has been a strange week for financials in SA, with indices riding a see-saw up and down with resource counters sitting on the other side.

There's little doubt SA-based banks and insurance companies are cheap - but are they worth buying?

"We're on a tightrope with resources versus financials," says Nigel McKenzie, head of research and financials at Stanlib Asset Management.

"Financials are probably the most difficult call to make at this stage. The view on resources is probably the clearest; our team remains bullish. The big challenge is when do we make the obvious switch into financials."

McKenzie emphasises this is a short-term consideration, and doesn't really change the asset manager's long-term outlook. But he adds there's been a lot of "table-banging" over financial share valuations - it's clearly occupying the minds of Stanlib analysts and fund managers.

In an earlier presentation Paul Hansen, Stanlib's director of retail investments, took a look at the SA market, including the perplexing question of when financial shares would re-rate.

Second-quarter numbers show the divergence in the market: resources up 13.4%, financial and industrials down 6.4%, within which the banking index lost 14.8%.

Local banks follow the downtrend overseas, where banks in the UK, Europe and US look very cheap. Median earnings multiples on banks range from around three times in the UK to just under eight times in Germany and the US.

But Stanlib's forecast for earnings growth one year out (which over the longer term should be reflected in share prices) has financials up by 11%, against 18% for industrials and 61% for resources.

Hansen warns short-term risks (for financials and industrials) are rising. "Headwinds of inflation, high wage increases, interest rates and the global slowdown are all risks to the downside."

However he adds bank shares are presenting a once-in-20-years opportunity. The dividend yield for Standard Bank, for instance, is at its highest level in 19 years.

Hansen's conclusion is to remain sceptical about financial and industrial shares "for the next year or so in the climate of rising interest rates, although some value is clearly emerging".

He feels investors could follow a "gradual buying programme" in bombed-out sectors like property, financials, many industrials and small cap funds.

Being underweight in financials, he's following his own advice for his personal portfolio, saying he?s easing money into the Stanlib Financials unit trust fund on a monthly basis.

McKenzie also feels there's too much uncertainty about future earnings of banks, and he sees the possibility of negative house prices as a risk as it could become the largest component of banks' bad debts. "The only time bank shares have traded below book valuations was in 1984 when house prices were negative," he says. What should investors do? Phasing money into a financial fund seems a sound idea, taking advantage of low share prices (that could fall further) but being placed in the market for the upturn. Buying individual counters is a tougher decision.

Investors with a longer-term view might consider dipping into selected counters now. You can wait for signs of a sustained upturn, but by the time you get in you might have lost 10% to 20% of the re-rating.

- Fin24.com