Putting the financial sector into perspective

There has been a divergence in valuation between the three major sectors – financials, industrial and resources – which began in the third quarter of 2007. This has continued into 2008 and can be seen in the decline in the financial index (it fell 10% in the six months to end February 2008) which spans all the sub-sectors, interest-sensitive and non-interest-sensitive alike. At the same time, the resources index rose 30%.

The trend has been supported by resource prices at record highs and the rand at local lows – factors that are highly supportive of resource company valuations – and the tighter interest rate and slower growth environment – which undermine financial and industrial company valuations.

The depressed financial environment has produced some exceptional value. This can be demonstrated in many ways. The most compelling argument comes from factor analysis. The three most powerful factors that explain stock returns are the price-earnings ratio, price-book value and dividend yield. Other factors (such as balance sheet stress and company size certainly matter, but no other factor is more significant than the aforementioned three factors).

While financials are offering value across the board, the opposite is true of the resources sector: it is hard to find value in resources; and these comments hold true for small, medium and large cap stocks across these super sectors.

At the broad sector level we see the following ratios:

	Current p:e ratio	10-year average p:e ratio	Dividend yield
Financial sector	9.3	12.5	5%
Resources sector	19.2	15.0	2%

It seems highly unlikely that resources stocks will be able to maintain the superficially high valuations shown in the table. Earnings would have to grow at some 30% this year for the p:e ratio to come in line with the long-term average, and these earnings already have record commodity prices built into them. It leaves the full burden of higher earnings on a weak rand.

The potential for commodity prices to rise further is also questionable. Much of the froth is attributable to financial speculation rather than physical demand for commodities.

Some of the South African mines also are under pressure from costs, not to mention the negative impact of power disruptions. Although the impact of these forces is variable, the gold and platinum mines could be more affected than the coal producers.

Globally, the price-book ratio of financial stocks to resource stocks has not been this low since 1950. The period since the 1950s includes the US savings and loan crisis, the Japanese bank crisis and the deep bear market of the 1970s. The same theme is seen in South Africa: compared to resource stocks (which are on exceptionally demanding price-book ratings), financials are very cheap – particularly banks.

The price earnings ratio on banks in South Africa sits at around eight times trailing earnings (more than a 40 percent discount to the market), whereas resources are priced on 20 times trailing earnings (more than a 20 percent premium to the market).

As an aside, it is probably worth recognising also that, given their commodity platforms, resource businesses have narrow moats, and profitability is the difference between globally-determined prices and costs, which gives companies little franchise strength. By contrast, banks often are owners of powerful franchises; consider RMB holdings, which has a range of powerful brands in its portfolio, including FNB, Momentum, Discovery and Wesbank. Powerful franchises mean wide moats.

In summary, people with investment horizons (years, not months) that have the ability to step away from the frenetic resource-driven momentum story will find exceptional value in banks.

Adrian Saville (pictured right) is CIO of Cannon Asset Managers and holds a Visiting Professorship in Economics and Finance at the Gordon Institute of Business Science.