Addicts to the basics of fundamental investing always remember one of the earliest strategies of stock picking that Warren Buffet once espoused. He selected stocks that traded at a discount to their book value.
The idea is simply based on the fact that the market was pricing these stocks cheap since their market value was way lower than their book value or net assets. This incidentally reminds me of Nigerian banks most of whom are notoriously synonymous with market valuations that are at a huge discount to their book values.
According to Nairametrics estimates, Nigerian banks currently trade at a 56% discount to their book value, one of the lowest of any sector on the Nigerian Stock Exchange. FCMB, Fidelity, Sterling Bank and Access bank rank amongst the highest discounted stocks trading at 28%, 25.1%, 32.1% and 33.2% respectively. So, does this mean Nigerian banks are significantly undervalued? Not too fast.
Stock pickers have over the years realised how flawed it can be to value companies simply based on their discount to book value. The conventional wisdom being that stocks that trade at a discount to book value may perhaps be a sign that the companies are underperforming or carrying a trailer load of dead assets that they can sweat profitably. Warren Buffet captures this quite brilliantly.
“In fact, if anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we’re looking at a poor business in the first case and a good business in the second case.”
In simple terms, a business that fails to deliver a significantly higher return on equity cannot be assigned a premium valuation when compared to one that delivers superior return on investments to its shareholders. It is therefore not about the profit that is declared by a company but how efficient it is at delivering profits. Again, Warren Buffet explains it, referencing a Japanese stock.
“Earnings are what determine value, not book value. Book value is not a factor we consider. Future earnings are a factor we consider. And as we mentioned earlier this morning, earnings have been poor for a great many Japanese companies. Now, if you think that the return on equity of Japanese business is going to increase dramatically…and you’re correct, you’re going to make a lot of money in Japanese stocks…if a company’s earning 5% on book value, I don’t want to buy it at book value if I think it’s going to keep earning 5% on book value. So a low price-book ratio means nothing to us. It does not intrigue us.”
This opinion perhaps explains why Nigerian banks continue to be valued at a discount to their net assets. Take for example, Nigerian banks and their return on average equity. In 2021, a year where we have seen record profits of a combined N889.2 billion for 9 of Nigerian most significant banks, they have also reported a combined 16.3% in return on average equity. Apart from Access Bank, GTB and Zenith all the banks in our radar posted a return on average equity of sub 18%. It gets worse.
Dividend is another important measure of returns for shareholders, especially for companies that are mature and have less room for exponential growth. Nigerian banks paid out 35% of their 2021 profits as dividends delivering a dividend yield of 9.5%. Nigerian Banks have also maintained a low dividend payout ratio for years citing the need to comply with capital adequacy ratio and Basel II requirements. Nevertheless, this strategy is now looking like a burden for banks as they now have to retain more capital without actually delivering a corresponding higher return on equity.
Banks’ shares also trade very high volumes daily making them very liquid and easy for anyone with them to buy and sell. With billions of shares traded daily, the forces and demand and supply makes it difficult for their share price to sustain a rally in the long run even if the fundamentals support the momentum.
Therefore, Nigerian banks more than any other sector need to encourage local participation in stock exchange not just via one of or cyclical bull runs but through a concerted effort to foster a habit of investing in shares among retail investors. They will also need to avoid some of the manipulative stock market practices of old that dissuaded millions of investors after they lost their money investing in Nigerian stocks.