As long-term growth investors, we shy away from most cyclical stories while gravitating toward structural ones. Inherently, banks are prone to credit cycles. However, with a solid foundation in bottom-up analyses, the right banks can potentially provide superlative and sustained performance over the long term.

Our investment in emerging market (EM) banks is guided by four core philosophies, which we discuss below.

1. Market Structures Matter Enormously

A concentrated market structure gives banks pricing power, allowing them to consistently generate returns above their cost of capital. Banking is an economy-of-scale business where the largest lenders enjoy inherent advantages in low funding costs, better risk-adjusted net interest margins (NIMs), and superior return on assets (ROAs). Exhibit 1.

Exhibit 1: EM Banks Have Materially Higher ROAs

Few banks in the world operate in such attractive market structures as Russia and Peru, where the leaders Sberbank and Credicorp control between 30% and 50% of the assets in the banking system. With their extensive branch networks and entrenched brand awareness, these are the go-to banks for customers’ deposits. This explains their competitive risk-adjusted NIMs and their long-term, superior ROAs of 2.0%-2.5%.

2. Long-Term and Durable Growth Lays the Foundation for Multi-Year Compounding Stories

It will surprise no one that banking sectors in emerging markets have relatively low penetration rates, providing a runway for growth.  However, we seek durable growth, meaning we look for banks that have the ammunition to fund their asset expansion and those in geographies where there is a second-order support for growth, typically from market share shifts.

A good illustration of this is the Commercial International Bank Egypt (COMI), which operates in a country where household and corporate debt were merely 7% and 35% of GDP, respectively, as of July 2017. COMI’s loan-to-deposit ratio was only 41% in 2017, meaning that more than half of COMI’s deposits were readily available to deploy for future loan growth. Such excess deposit “ammunition” supports COMI’s multi-year growth story.

Another great durable growth story is Kotak Mahindra Bank (Kotak) in India, which has garnered growth from both India’s increasing credit penetration as well as share gains from the state-owned competitors. Exhibit 2. Kotak’s underleveraged balance sheet (Tier 1 ratio of 17.9% in the third quarter of fiscal year 2018, the highest among its peers) will allow it to fund its loan growth for several years to come. 

Exhibit 2: Indian Private Banks Have Been Outgrowing Their Public Peers

3. Look for Companies with Massive Optionality

We seek to own companies with massive optionality that others ignore because it requires bold imagination and patience. Digital banking is one such optionality. In recent years, many EM banks have made significant digital investments to follow their digital-native customers. This shift seems incremental at the get-go, but will likely bring transformational results in the next few years. The first result is dramatic cost reduction, thanks to a smaller branch footprint, automated services, and targeted customer acquisition.

The second result is the ability to cross-sell a whole host of financial products, including personal loans, wealth management, and insurance. The result is a boost in fee and investment income, which historically have been low for most EM banks. For banks like FirstRand in South Africa, whose retail unit (FNB) saw 88% of transaction value done digitally in 2016, the upside from digital, particularly in reducing its high cost-to-asset ratio of 3.5%-4.0%, provided that optionality.

4. Own Only Best-in-Class Bank Franchises

The key pillar for our approach to investing in EM banks is to own only best-in-class bank franchises. The hallmarks of these franchises are world-class management teams, the highest standards of corporate governance, and durable competitive barriers (e.g., funding, distribution, and brand). We don’t concern ourselves with low-quality circumstances. It is no surprise that our bank holdings are typically the best-run, highest-quality banks in their respective geographies.

Valuation Drivers for EM Banks

While our core philosophies define our investable universe, valuation dictates what eventually goes in or out of the fund.

Our approach to valuation is centered on three fundamental drivers of the banking business: return on equity (ROE), cost of equity (COE), and growth. Exhibit 3.

Exhibit 3: Gordon Growth Valuation Model

These three drivers inform our views on the long-term valuation metrics of a bank, including price-to- book, price-to-earnings and dividend yield. We work relentlessly to achieve differentiated insights on the three valuation drivers. Indeed, rather than employing a rigid formulaic approach, it requires imagination to uncover where true value really lies. Calculations of ROE are imprecise if you only extrapolate from the recent past, or ignore the stage of the credit cycle an economy is in. COE assumptions are prone to error without an inherent understanding of the macroeconomic context. We believe that our decades of experience investing in emerging markets, coupled with our proprietary models, allow us to uncover compelling investment opportunities that others may have missed.

What We Don’t Do

Despite being one of the largest investors in emerging markets, we have ruled out most EM banks from our investable universe. Therefore, we believe it is just as important to know what we don’t do as it is to know what we do.

Tolstoy once wrote, “All happy families are alike; each unhappy family is unhappy in its own way.” We would posit that all good banks are alike; each lousy bank is lousy in its own way. While there is only one way to practice good banking, there are numerous ways to conduct bad practice. We will highlight two of the more serious problems in banking, which we try to avoid at any cost.

In any bank, loan provisions are management’s best estimate for potential losses from their lending activities. If management is determined to print spectacular short-term earnings, they will tend to under-report provisions by delaying recognition of bad loans. Such delays can go on for years before the problem is admitted, and by that time, it is often too late. This is the first and probably most common issue in banking.

The second problem arises from the relationship between the government and the banking sector. Credit formation usually leads to higher economic activities. Therefore, it is not uncommon to see a government require its state-owned banks to accelerate loan growth to support its own growth agenda. When done indiscriminately, the state-owned banks start to loosen their underwriting standards and accumulate loans which will never be paid back. Sooner or later, the banks will collapse under the weight of their own bad loans. This is essentially a classic moral hazard: These state-owned banks don’t work for their minority shareholders (in other words, us); they work only to support the government agenda.

It is no accident that to date, we have avoided Chinese state-owned enterprise (SOE) banks altogether. The Chinese SOE banks have been the Communist Party’s vehicle to fund its high-growth agenda. Consequently, there is little guarantee on the quality of their debt underwriting. Furthermore, “ever-greening of debt” – a practice of extending new debt to ailing enterprises to pay for old debt – is common among the Chinese SOE banks. The combination of aggressive loan growth and debt recycling is unsustainable in the long run. Moreover, the asset/equity leverage ratios for Chinese SOE banks are among the highest in the world (at greater than 13x). To put it another way, if investors miscalculate the true loss on the banks’ assets by just 3%-4%, half of their equity will be wiped out.

A final approach we avoid is the notion of making a “top-down macro bet” by buying banks, often seen as a proxy for a country’s economic health. As investors of banks in two dozen countries, we often get asked how we deal with macro risks. Regardless of the sector, our longstanding philosophy on this has been the same: We invest in companies, not countries. An unattractive bank is always unattractive to us, no matter how great its macro wrapping looks. We will never own an inferior bank just to participate in a superior macro story.


Our two largest positions are both Indian companies: HDFC Ltd and Kotak Mahindra Bank. These are the highest quality financial institutions in India, which we believe will continue to compound faster than the market and generate satisfactory returns over the next decade.

In Russia, we own shares in Sberbank. We believe this is the most under-valued and high-quality bank in emerging markets. The bank has an envious liability franchise and under-appreciated digital capability. There are multiple positive catalysts from top-line growth, cost reduction, and potential multiple re-rating from a higher dividend payout. While recent geopolitical events have impacted near-term performance, the underlying fundamentals remain intact, and we are confident that our practiced patience will continue to be rewarded.

FirstRand, Credicorp, and Itau are our best-in-class bets on growth normalization in South Africa, Peru, and Brazil, all of which are commodity geographies. We believe there are no better large-scale financial institutions than these three in their respective countries.

Inbursa is an idiosyncratic bet on that bank’s ability to build its retail franchise, thereby lowering funding costs, improving leverage and lifting ROE. Inbursa is a misunderstood, neglected bank in Mexico with an unusually under-levered balance sheet and massive retail optionality.

We expect that this unique portfolio of top-quality banks will outperform in the next three to five years.

Top 10 Stock Holdings by Issuer

Taiwan Semiconductor Manufacturing5.9%
Alibaba Group Holding Ltd.5.2
Tencent Holdings Ltd.4.8
Housing Development Finance Corp.3.4
Novatek OAO3.1
Glencore Plc2.9
Jiangsu Hengrui Medicine Co. Ltd.2.4
AIA Group Ltd.2.3
Kotak Mahindra Bank Ltd.2.3

All holdings are as of 3/31/18, subject to change.