Betting on Philippine banks

20 Apr 2017

THE PHILIPPINE Stock Exchange Index (PSEi) recently broke out of a long consolidation.

For over 50 trading days, the index was caught in a tight 300 point/4% range; an event so rare that the only analog we could find happened in 2003. Foreign funds have returned as net buyers in a big way since the start of April but the source of the market’s optimism is from domestic investors and is apparently based on the purported benefits of proposed tax reform measures and the administration’s promised infrastructure push.

Market prognosticators and investors, in general, have swept negative factors aside including regulatory, policy, and legislative changes that affect a majority of listed companies.

Mining companies, for example, have been hit hard by the Environment Department’s decision to suspend or close dozens of mines. On the other hand, labor and related costs are expected to increase over time on the back of the Department of Labor’s DO 174 and the imminent hike in social security pension contributions (a back of the envelope calculation shows that the business process outsourcing industry alone will have to shoulder approximately P7 billion annually if both the contribution rate and maximum salary credit are raised to 12.5% and P20,000, respectively, as proposed by SSS management).

Meanwhile, housing-focused property companies will be impacted by the proposed withdrawal of VAT (value-added tax) exemptions for low-cost units. Also, the Philippine Competition Commission remains keen to review the buyout deal involving San Miguel Corp., PLDT and Globe Telecom and has promised to look into alleged anti-competitive behavior in several industries including cement and power generation.

Next, taxes on consumption will effectively rise with the looming excise tax hikes on fuel and automobiles. This list can go on but the bottom line is that little or no heed has been paid to a tightening regulatory environment that threatens to erode the aggregate profitability of publicly listed companies.

To be sure, many of the regulatory changes are necessary. The rights of labor to security of tenure, for example, as embodied in DO 174 is expected to benefit a large swathe of the labor force. Nevertheless, the market’s seemingly cavalier attitude toward these threats should be considered a red flag.

So, should investors totally avoid Philippine equities? Not at all. Despite the aforementioned concerns, some sectors stand out for their potential to deliver strong returns both in the near term and for the long haul. One of these is the banking industry.

Banks are no strangers to regulation.

To avoid a repeat of the Asian financial crisis, the Bangko Sentral ng Pilipinas (BSP) mandated reforms and benchmarks that are stricter than international standards. The latest round of initiatives, in fact, forced many banks to shore up their respective capital bases in order to meet present and future requirements. While these have crimped profitability as measured by returns on equity and assets, especially when compared to regional peers, Philippine banks stand out as among the most financially sound in the world. What really needs to be emphasized, however, is that banks are relatively immune from the raft of regulatory changes enumerated above. Moreover, the balance of the BSP’s pipeline of policy changes may be net positive for banks in the near to medium term.

First, central bank officials have said that as part of the interest rate corridor implementation, commercial and universal banks’ reserve ratios (RR) will be lowered from the current 20% (the highest in the region) to become more in line with regional peers. To be clear, the BSP has indicated that RRs will be cut very gradually. Nevertheless, banks will be able to lend more over time and therefore significantly improve profitability ratios.

Second, at least one of the potential nominees to replace Governor Tetangco has said that benchmark rates should be hiked this year. Slightly higher rates will not dampen demand for credit and should thus help improve banks’ net interest margins over time.

Banking stocks are attractive for other reasons.

Bullish corporate and consumer sentiment are translating into robust demand for corporate and consumer loans. Although somewhat indirect, banks are therefore good proxies to ride the country’s current economic expansion. Moreover, the potential for growth is huge given that Filipinos remain under-banked relative to the region.

The National Baseline Survey on Financial Inclusion conducted last year revealed that only 43.2% of Filipinos had savings and of this number, less than a third (32.7%) put their savings in banks. Also, based on the latest BSP data, 37% of the Philippines’ over 1,600 cities and municipalities -- including nearly a fifth of all 1st and 2nd class towns -- have no banks at all. Loan growth has the potential to grow even further if the government’s ambitious infrastructure plans come to fruition.

Finally, it bears emphasizing that financial stocks are trading at undemanding valuations.

On 2017 earnings estimates, the nine biggest banks by market value have a weighted average price earnings ratio of only 11.6x. As a group, it is trading a discount of more than a third relative to the benchmark index but individually, a few offer discounts of closer to 50% compared to the PSEi.

On a price to book basis, most banks are also trading close to or below their historical five year averages.

This indicates that the downside should be limited, the current risk reward profile is attractive, and banking stocks have underperformed for quite a long stretch.

More recently, the PSE’s financial sub-index has firmed up (financials have beat the PSEi by 4.4% since June last year and by 2.5% year-to-date) and should continue to do so over the next six to 12 months.

Views and opinions expressed in this piece are those of the writer’s and do not reflect the policy or position of BusinessWorld. This piece is for information purposes only and should not be construed as a recommendation, an offer, or solicitation for the subscription, purchase, or sale of any of the security(ies) mentioned.

Raymond “Nicky” Franco is a Certified Public Accountant and received his Chartered Financial Analyst (CFA) designation in 2000. He is the Head of Research of Abacus Securities and the head of its online trading arm, MyTrade (