Michael Abrahams knows banking. Since receiving his PhD in Economics from UC Berkeley, he has helped craft bank policy in Washington, analyzed bank financials on Wall Street, served on the boards of financial institutions, and advised a village-level savings and loan association in Uganda. Now he’s putting his extensive expertise to work as the General Partner of the New Markets Financial Fund, LP, which invests primarily in firms that provide banking services to underserved communities. African stocks constitute over 50% of the fund portfolio, which has posted a 16.6% CAGR since inception in January 2007 through year end 2010.
Mike graciously agreed to give me some insights into his investment approach last week.
You invest primarily in financial firms that cater to the un-banked. Why have you focused your fund in this way?
Michael Abrahams: This is an extraordinarily exciting market that is being pushed by both the demand and supply sides of the equation. The World Bank has estimated that there are 2.5 billion unbanked adults worldwide; while some have incomes too low to be served, this hurdle is declining every year. In addition, the demand for banking services increases more than proportionately with income, that is as incomes rise, the demand for banking rises even faster. This large and growing demand is being met by an increasing supply of services: technology and greatly improved operating strategies are enabling financial institutions to profitably provide the small accounts and transactions needed by many of these potential customers. While banking in the US is characterized by overcapacity, weak (if any) profitability and negative growth, our market, largely in emerging and frontier markets, is rapidly growing, has wide margins and is providing tremendous benefits to its customers.
It sounds like a pretty specific niche. How large is your investment universe?
MA: It is bigger than you may think. Last year, we totaled up the market cap of all publicly traded banks in emerging and frontier markets that we could find and it came to $2.3 trillion. This is an overestimate of our universe since there are banks in this group that serve a different niche within emerging and frontier markets than we have an interest, for example, wealthy individuals or corporations. However, it does give you an idea of the magnitude of this market.
It must have been rough sailing for these stocks a few years ago. How did you navigate the 2008 financial crisis?
MA: That was our second year and it was a challenge. However, we had been concerned since 2005 about the US real estate market and the US banking system. In 2008, we were heavily short US financials, something that helped mitigate our losses to about half that of the S&P500.
Tell me a bit about your investment process. What criteria do you use to size up a potential investment?
MA: We first make sure that we are relatively comfortable with the country where the company is headquartered. Then we’ll examine whether their strategy has a reasonable chance of success. When we find a company whose market and strategy we like, we evaluate its returns, how it generates those returns and how well it does so by looking at some of the contributors to earnings quality such as the net interest margin, the sources of non-interest income, and the level and trends in problem assets. I then like to rank potential and current investments by their PEG ratio to give me some idea as to how expensive the shares may be relative to other companies’ shares.
Sometimes companies change their strategies — particularly in a market that is growing in many new directions like this one. When they do, we re-evaluate our position. For example, African Bank Investments (ABL:SJ), a South African microlender, purchased one of the largest furniture dealers in South Africa a few years ago in order to accelerate the growth in their loan portfolio, in this case with furniture loans. But the retail furniture business is very different than the loan business and we sold our position.
You made a great call on a South African firm called Capitec Bank Holdings (CPI:SJ), which you’ve ridden to a 411% gain. What tipped you off that the stock would be a winner?
MA: Here was the key for me: the bank understood their target market, the un- and underbanked of South Africa, and designed the bank’s products and services specifically to meet their needs. None of their business appeared to be a rehash of existing products and services designed for wealthier customers. I can’t overstate the importance of this —translating an ATM panel into different languages, as we have seen in the US isn’t enough, it isn’t even a start. I felt Capitec had the right products and had done everything imaginable to drive their costs down so that they could profitably offer small accounts and services. In addition, unlike many others who serve or try to serve this market, Capitec has a strong focus on deposits. This is critical for their customers’ long term financial health and development and for Capitec’s long term funding stability. They had little to no competition among formal financial institutions, although some has since developed, and faced a market in South Africa of millions of potential customers. And they had margins you could drive a truck through. To make it better from my own selfish perspective, the little research coverage they got kept saying they were too expensive. They were too expensive if you compared them to FirstRand (FSR:SJ) or Standard Bank (SBK:SJ), but neither of them were growing at 40%+ a year with high returns on equity on unlevered capital bases.
And (you knew I was going to ask this) what was one of your biggest losers?
MA: Blue Financial (BFS:SJ). They had a really great story as a pan-African microfinance lender. However, they couldn’t execute on their strategy. I think in part because it was a more complex task to develop a pan-African lending platform than they expected and underwriting suffered as they sought rapid growth. They probably needed a more experienced and cautious management and board team than they had.
What is your biggest challenge as an Africa investor?
MA: The biggest challenge is politics. In the first quarter of 2011 alone, Egypt closed their market for almost two months and Cote d’Ivoire moved their exchange to Mali for a few months after the forces of the former President raided their offices. Turmoil continues there today. And on a smaller level, Net1UEPS (UEPS:US) has been volatile and a very poor performer for three or four years because of the ongoing uncertainty regarding contract discussions with their largest client, the South Africa social benefits administration.
The next biggest challenge is inadequate disclosure. It does vary. Many South African companies have excellent disclosure. Other countries and companies have much more limited disclosure. For example, some of the banks we have looked at in the Cote d’Ivoire release their full year end financials in October with the half year results about a month later.
Do you see any bargain African banks right now?
MA: There are many attractive investment opportunities. If I had to pick one today, I would pick Letshego (LETSHEGO:BG), the Botswana-based micro-lender. And we are looking very closely at expanding our investments in companies playing key roles in providing mobile phone banking. Paul Volcker said in 2009 that the only innovation in banking in the past 20 years was the ATM — I would add mobile phone banking which will have a much bigger impact.
You recently traveled to Nigeria. What is your take on its banking sector?
MA: Nigeria is a tough one. It is the most populous country on the continent with well-recognized problems with resource-dependency and corruption. However, things are improving on many fronts including banking and the regulation of banking which is more than we can say about the US. I will feel more confident in my ability to evaluate Nigerian banks when they shift to IFRS accounting from their current use of Nigerian Accounting Standards. There is huge potential in this market and there are some serious and dedicated people and institutions working on reforming it.
You don’t just invest in African banks, you’re personally involved in setting up village-level savings and credit associations on the continent. Has this work informed the way you manage your portfolio?
MA: Two experiences have influenced the way we look at our investments. The first is work training people in West Africa how to establish savings and credit groups through their local churches. The second was closer to home and was financing and then serving on the board of a Los Angeles based inner city check cashing company. Through both, I saw that the lives of the unbanked can be tremendously improved, if not changed, with basic banking services. But these services have to be designed to fit their needs; that is, offering them a $1000 CD, even if it is in Spanish, is not much help. But a savings account that they can regularly add a couple dollars to every week, pay some bills from and not be annihilated by service charges can be a hugely beneficial product. We look for well run companies able to profitably deliver products like this.
Disclosure: The New Markets Financial Fund holds a long position in Capitec Bank Holdings. Ryan Hoover holds long positions in Letshego Holdings and Net1UEPS.