Every once in a while, the stock market offers you a gift.
In Kenya, this appears to be one of those times.
At the beginning of last week, shares of Kenyan banks were already trading at valuations near their lowest in a decade.
Then, on Wednesday, things got crazy.
In a surprise move, President Uhuru Kenyatta signed a law that put a ceiling on banks’ lending rates and a floor under deposit rates.
Interest rates on loans are now capped at four percentage points above the benchmark interest rate, which presently stands at 10.5%. Deposit rates, meanwhile, must now be at least 70% of the benchmark rate.
As you might imagine, the market didn’t like this news one bit.
Bank stocks tanked. They all ended the week at least 6% lower than where they started it. And the prices of three of them, Co-operative (COOP.NR), Equity (EQTY.NR), and NIC (NIC.NR) plunged 23%, 22% and 21%, respectively. The bloodletting continued on Monday with four banks dropping another 9%.
When the closing bell rang on August 29, the price-to-book ratios and dividend yields of the ten largest Kenyan banks looked like this.
Kenyan Bank Valuations as of August 29, 2016
| Company | P/B Ratio | Dividend Yield |
|---|---|---|
| Barclays Bank Kenya (BBK.NR) | 1.1 | 11.5% |
| CFC Stanbic (CFC.NR) | 0.7 | 9.6% |
| Co-operative Bank (COOP.NR) | 0.8 | 8.2% |
| Diamond Trust Bank (DTK.NR) | 0.9 | 1.8% |
| Equity Group (EQTY.NR) | 1.3 | 7.5% |
| HF Group (HFCK.NR) | 0.4 | 10.0% |
| I&M Holdings (IMH.NR) | 0.9 | 4.5% |
| KCB Group (KCB.NR) | 0.8 | 4.1% |
| NIC Bank (NIC.NR) | 0.6 | 5.2% |
| Standard Chartered Kenya (SCBK.NR) | 1.3 | 12.1% |
What to Expect Now
Now, I don’t want to spend too much time discussing the merit of the new regulations, but, in their wake, I think the following three things are near certainties:
- Banks’ growth rates will slow.
- Large banks will continue to find ways to make money.
- Banks’ asset quality will improve.
Let’s briefly consider each one in turn.
Bank Growth Will Slow
At present, all Kenyan banks do at least a portion of their lending at interest rates greater than 14.5% (the new, effective maximum rate). And they all pay interest on at least a portion of their deposits at rates lower than the new minimum (7.35%).
Thus, with the new cap and floor in place, the margin between the amount of interest a bank collects and the amount of interest that it pays out will be squeezed, making it tougher for the banks to grow net interest income.
Large Banks Will Remain Profitable Over Long-Term
But don’t shed too many tears for your banker. Most large banks will be just fine.
Sure, banks that do a lot of business with small, riskier customers (e.g. Equity and Co-operative) will likely be hit harder than their peers, but they will find a way to remain profitable in the new environment, whether it be through more efficient loan underwriting, higher fees, or new terms for savings accounts.
It’s important to note that usury laws are not unusual in capitalist economies. In fact, they exist in 49 of the 50 U.S. states (Utah’s the only exception).
Asset Quality Will Improve
Now that the cap on interest rates is in place, the first step most banks will take is to reduce the amount of lending they do to riskier borrowers. After all, why would a bank lend to a small business at a rate of 14.5%, when they can invest in a government bond yielding 15% instead?
As banks shift away from high-interest, unsecured lending, bad loans will no longer present a major threat to the quality of their assets. And, in theory, a bank’s share price should at least be roughly equivalent to its book value per share.
A Conservative Forecast
So, given the above, what kind of returns might we expect from the bank stocks over the next five years?
Let’s make some assumptions for what we’ll see between now and the end of 2021.
- Banks’ average growth rate will be cut by a third.
- Bank stocks currently trading at a premium to book value will see this premium cut by a third.
- Bank stocks currently trading at a discount to book value will see their price-to-book ratios remain at their current level.
Please note that these are strictly assumptions, but I believe them to be relatively conservative. (Let us know in the comments if you think any of them are way off the mark.)
Now that we’ve made these assumptions, we can plug in the numbers and arrive at a forecast return (including dividends) for each Kenyan bank stock. They appear in the chart below.
| Company | Est. BVPS Growth* | Est. P/B Ratio* | Est. Annualized Return* |
|---|---|---|---|
| Barclays Bank Kenya | 3.9% | 1.1 | 12.5% |
| CFC Stanbic | 2.7% | 0.7 | 9.9% |
| Co-operative Bank | 10.5% | 0.8 | 17.1% |
| Diamond Trust Bank | 16.2% | 0.9 | 17.7% |
| Equity Group | 13.4% | 1.2 | 17.8% |
| HF Group | 6.1% | 0.4 | 14.2% |
| I&M Holdings | 14.4% | 0.9 | 18.1% |
| KCB Group | 15.7% | 0.8 | 19.0% |
| NIC Bank | 13.1% | 0.6 | 17.4% |
| Standard Chartered Kenya | 8.6% | 1.2 | 16.6% |
* Forecast to 8.31.2021
A Bevy of Bank Stock Bargains
So, as you can see in the chart above, most Kenyan bank stocks now appear priced to deliver annualized total returns well above 16% over the next five years. KCB, I&M, Equity, DTB, and I&M look like the pick of the litter with 19.0%, 18.1%, 17.8%, and 17.7% forecast returns, respectively.
And if my assumptions turn out to be too conservative, which I believe is more likely than not, the returns to long-term investors at these prices could be very special indeed.
Disclosure: At time of publication, I held a beneficial interest in shares of KCB and I&M Bank.
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