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Times are tough, but we’ve been here before

‘Banks are already discounting, in our view, the prospect of a downgrade’ – Peter Linley – Old Mutual Investors’ Fund.

SIKI MGABADELI:  Political turmoil and fears that South Africa’s sovereign credit rating could be downgraded to junk status have been tough on local banks. In the wake of Nenegate the share prices of banking stocks collapsed in a heap. They also came under pressure when the NPA announced that Finance Minister Pravin Gordhan would be charged with fraud, albeit to a lesser extent.

So should you be buying banks? Let’s ask Peter Linley of the Old Mutual Investors’ Fund. Peter, thanks so much for your time today. Just for those who are uninitiated, why do banks suffer from a confidence crisis at times like this?

PETER LINLEY:  Well, your banks are very exposed to the economy. They lend out to businesses and if those businesses struggle in an environment of rising interest rates the banks will be directly affected with bad loans.

The other thing is, when you look at valuing banks, for instance, you would take a line from bond yields, and bond yields in that kind of environment could well rise. And that again is a sign of lack of confidence in the economy. So a downgrade like that would negatively impact valuations.

SIKI MGABADELI:  I suppose with the threat of a downgrade, then, there is still room for a further spike in bond yields and currency weakness on the short-term horizon?

PETER LINLEY:  Well, I guess that’s what we as investors are continually debating and trying to understand. From a sentiment point of view, I would expect that you would get some sort of volatility around any announcement if we do get downgraded.

But what you also have to look at is to try and understand what has already been discounted in the price of the currency or the price of interest rates or the price of bank shares, for instance. In my view you’d probably find that there is a fair bit of bad news already discounted in those asset classes or assets themselves when you do the analysis.

SIKI MGABADELI:  So what does it mean, then, for somebody who is looking at investing in banks or who is already invested and is weighing their options? You guys are invested in some of our big banks. What’s your thinking at this point? Are you staying, are you dumping, are you buying? What’s your strategy?

PETER LINLEY:  We’ve been buying. The rationale for that is when we look at any equity any share, any company, in terms of determining the valuation we look at a bull-case scenario potential, which is an optimistic scenario; we look at a base case scenario, which obviously forms the basis of our view; but then we also look at a bear-case scenario – in other words, what is the worst-case kind of valuation for this company?

And when we do that work on the banks, we are coming up with a valuation on the banks which is a lot higher that where they are trading at at the moment. In fact, the banks are trading close to our bear-case valuation. In other words, all that that’s saying is that the banks are already discounting, in our view, the prospect of a downgrade.

But it may be that on the day of a downgrade you could have sentiment driving the prices lower. But on a three-year view we think that banks do offer good value.

SIKI MGABADELI:  Have you done this with all of our banks? Can you give us one example?

PETER LINLEY:  Ja, we’ve done it with all of the banks. You take Barclays Group, for instance – that’s currently trading at around its bear case, so there’s about 10% upside to that. The price is, when I last looked, R148/150. The bear case is round about where the valuation is at the moment.

So in our view you are not taking that amount of risk by buying into bank shares at the moment.

SIKI MGABADELI:  Having a quick look at the rand before you wrap up, some people obviously were surprised that we did not see the rand weaken to the levels this time around that it did in December last year. Can we read into that that it’s already discounting a lot of this bad news more than it did in December last year?

PETER LINLEY:  I think that generally you’ve got emerging-market currencies on a stronger footing. Commodity prices have picked up or steadied from this continual decline that they had last year, and you’ve had some improvement.

To some extent the market kind of begins to get used to the events and so the reaction to them is a lot less. But the rand is looking cheap on a relative basis and on a purchasing power basis. So we think that there is potential upside, but there are headwinds to the currency at the moment.

SIKI MGABADELI:  And we know what they are. Thanks for your time today. Peter Linley is with the Old Mutual Investors’ Fund.

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