For contrarian investors, the opportunity set resides in disliked and uncomfortable environments. It’s a necessary condition for the market to think you’re foolish, but it’s not sufficient, one’s analysis and valuation must be correct. The necessary condition is satisfied by researching Russian equities, most non-Russians consider this idiotic. The sufficient condition is more difficult because at best we’re making educated guesses. In this article I’ll be making an educated guess regarding Sberbank’s (OTCPK:SBRCY) expected return, the estimate is not guaranteed, and the future could deem it foolish.
Sberbank dominates Russian banking. As shown in the chart directly below, it holds 44.6% of retail deposits and 24.1% of corporate deposits. It benefits from a 32.8% market share of the corporate loan market and a 41.4% share of the higher-growth retail loan market (where household debt to GDP is approximately 16.5%).
The bulk of its operating income comes from net interest income, plus fees and commissions.
Fees and commissions continue to grow strongly whilst net interest income has benefited from a lower interest expense in recent years.
Net income has grown despite the Ukraine crisis and sanctions which emerged from it.
Looking at Sberbank’s competitive positioning, the domestic competition is weak and new international competitors are unlikely to enter the market anytime soon because of geopolitical tensions.
Beyond traditional banking, Sberbank aspires, and is acting to become a future technology conglomerate with subsidiaries in: health, education, travel, law, marketing, e-commerce, real estate, business process outsourcing, cloud computing, cyber security, and more. A full description of this requires a separate article because there’s a lot of information. When the market sees Sberbank as a tech/banking hybrid, its P/E ratio will likely expand. In the short term, 2020 revenue from new-tech is forecast at RUB70 billion, so ignoring the cost of revenue which isn’t provided, this gross figure equates to 4.33% of 2017 operating income which isn’t currently material.
When you chart the world’s publicly traded banks, who have a market capitalization above US$5 billion, Sberbank looks comparatively cheap; banks with an ROE of 18-20% generally trade at 1.5 times book value or more.
The counterargument to cheapness would be that Sberbank will be less attractive in the future with a lower ROE trending towards 15%, and that this is inevitable because of the bank’s size. The inevitable decline of ROE explains why the bank is shifting its operational focus to technological businesses for additional growth.
Dividend Discount Model
In my opinion, my model is highly conservative because it assumes no net income growth from 2020-2023 and it uses a terminal growth rate of 1.5% after 2023. This conservatism offsets the reality that future cyclicality in earnings, dividends, economic growth and geopolitics can’t be predicted.
Rather than building a discount rate that lacks consensus and proclaiming a target price, I’ve matched the calculated intrinsic value to the current U.S. stock price to imply what the required return is for investors using my model:
The model suggests that investors currently require a total return of 14.20% per annum, which includes dividends, to purchase the stock. If the future produces higher net income and dividends the actual return should be higher. If the future produces lower net income and dividends the actual return should be lower.
In seven of the last ten years Sberbank has traded with a price to book ratio that is higher than the current ratio of 1.10.
In seven of the last nine years Sberbank has traded with a P/E ratio that is higher than the current ratio of 4.30.
The historical record implies that the stock may be cheap.
I think it’s reasonable to conclude that Sberbank should provide a 14.20% return over the long term based on discounted dividends. This conclusion is supported by implied cheapness from ‘price to book versus ROE’ trading comparables as well as Sberbank’s historical price multiples.
Noting that free lunches are rare and that securities are usually cheap for a reason, I’ll briefly discuss the risks driving this cheapness in the last section after highlighting some key points.
Some key points to be aware of
Firstly, sustainably high returns on equity in the medium to long term will require net interest income growth. This has declined recently and will require a new credit cycle to expand materially.
In a perfect world, the Donbas region would see peace after the 2019 Ukrainian elections, the EU would lift sanctions, declining risk perceptions would strengthen the Ruble, a strengthening Ruble would decrease inflation, allowing the central bank to lower rates and a new credit cycle to begin. We’ll see.
Secondly, recent boosts to net income have been aided by declining provisions and an improving NPL ratio. Further gains are possible but they’re finite.
Thirdly, recent boosts to net income have been aided by an improving operating expense to operating income ratio. Further gains are possible but they’re finite.
Some of the risks
Russia's GDP growth is sensitive to energy prices:
And economic performance transmits to Sberbank's non-performing loan ratio affecting profitability.
If oil prices fall dramatically like they did in 2008 or 2014-15, the non-performing loan ratio should rise and Sberbank investors would likely suffer. This article assumes that Russia's GDP averages 1.5%, and Brent oil averages $60 per barrel over the long-term.
Swings in economic growth may be amplified by geopolitical misbehavior and resultant sanctions. I could be very wrong, but I don’t think that Sberbank will face “nuclear” sanctions as threatened in the DETER and DASKAA acts which appear to have been shelved. The trend is for sanctions that target Kremlin-linked individuals to put pressure on Putin; it’s generally agreed that sanctions shouldn’t harm the Russian populace who are innocent (e.g. RUSAL continues operating but Deripaska loses control). Threatening Russia’s banking system was a bluff, that was successful, to stop Russia from “meddling” in the 2018 mid-terms (evidence of rational behavior by Putin). Treading cautiously, with Putin focusing on economic growth, I don’t think he’d plan any activity now that would jeopardize the banking system. The risk for me, is how he reacts to external events, with the Kerch Strait incident being a recent case in point. I could be wrong though, and the US could harm the Russian banking system yet, and/or force people to sell their stock.
Shifting to future returns, the expected return of 14.2% is not static. If risks decrease, investors may only require a 10% return and hence bid the stock price up. If risks increase, investors may require a 20% return or more causing the stock to fall to a level where that eventuates. It’s important to recognize that equity returns will never be linear, the stock could rise, fall, or go sideways for years.
On competition, the net interest margin should decline in the future as the banking system matures and competition intensifies; Sberbank’s net interest margin is high relative to global peers.
Finally, this article has partially relied on guidance from Sberbank for future ROE (in 2020), dividend payouts, and net income (in 2020) which appears reasonable to me, ceteris paribus. If reality deviates from the guidance in a negative manner, the stock should fall.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SBRCY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.