Mohamed El-Erian recently highlighted a perceived disconnect between emerging market stocks (EEM) and fundamentals on Twitter.
The rebounding emerging markets index is every bit as peculiar as the sharp rebound in domestic indices since the lows of earlier this year, which, despite not showing quite as impressive of a rebound as the S&P 500 (SPY), is astonishingly close to flat for 2020.
Looking deeper at performance in the United States reveals that, while a large swath of the stock market has showed a substantial recovery from the March lows, some parts have benefited more than others. The equal weight S&P 500, for instance, remains lower on the year, and the mid-cap and small-cap indices have performed substantially worse.
The performance of emerging markets also requires investors to look somewhat beneath the surface. Asian emerging markets, which dominate the index, have largely recovered, driven in part by large components of the index such as Alibaba (BABA), Tencent (OTCPK:TCEHY), and Taiwan Semiconductor (TSM). Meanwhile, the value-driven Latin American indexes have significantly underperformed.
This, to a certain extent, makes sense. The pandemic has only recently begun to be brought under control in much of the Americas, and significant money printing is not a tool at their disposal, which also limits fiscal flexibility. Most forecasts now have GDP in the United States shrinking by about 5% this year, while, in China, it is set to show slight growth of 1% and in South Korea a relatively small (for 2020) contraction of close to 2%. The Indian market, with GDP in the country falling by perhaps 8% to 9% this year, has been powered by some of the country’s biggest companies, including massive conglomerate Reliance Industries and IT and outsourcing firm Infosys (INFY). Contrast that with many Latin American indexes where the economic shocks have been statistically as bad as India’s, but without the kind of performance in many cases from individual-story components, as has been the case in India.
The challenges are going to be great in many emerging economies even in an optimistic scenario where the virus stays largely contained until a vaccine comes along. But the question now is whether prices in some of these countries are more than fully discounting that fact. I would argue that investors looking for bargains may find more today in Latin America than any other part of the world. This summer, I highlighted Grupo Sura (OTCPK:GIVSY), for which the ADR presents some liquidity constraints for larger investors. I still believe that Sura owns high quality assets while being extremely undervalued. Today, though, I highlight another Colombian financial group for which a pretty strong long case can be built, Grupo Aval (AVAL).
I last wrote about Grupo Aval at the beginning of 2019, when a scandal involving the construction of Ruta del Sol was pressuring the share price. Since that time, Aval has outperformed its closest rival Bancolombia (CIB) as well as the Colombian market (ICOL). Up until the pandemic began affecting financial markets, it was also outperforming the S&P 500. The sell-off, however, has been steep with Aval still about 43% off its highs even after accounting for the rally since late March.
Aval’s business can be divided into four broad components: Colombian commercial banking, Central American commercial banking, merchant and investment banking, and pension administration.
The Colombian banking business is conducted through four commercial banks for which each bank has a different geographic, demographic, or loan segment focus. Aval owns anywhere from about two-thirds to more than 90% of each of these banks. Some of the remaining interests are owned by the Sarmiento family, which controls Grupo Aval itself, and the remaining float of the banks trade in Bogota.
Banco de Bogota also fully owns and consolidates BAC Credomatic, a Central American banking group purchased from GE Capital in 2010 for $1.9 billion. Since that time, three additional acquisitions have been made for about $1.4 billion, including two in Panama, a $490 million buy-out of BBVA Panama in 2013 and a recent $510 million acquisition of Multibank Financial Group. Following the Multibank acquisition, the Group is now the third largest Panamanian bank, with an 11% deposit share in the country. About 38% of the loan book at BAC now comes from Panama, followed by Costa Rica at 23%, Guatemala at 16%, Honduras at 10%, El Salvador at 9%, and Nicaragua at 4%.
Porvenir is the second entity consolidated at Banco de Bogota. It is one of only a handful of companies legally able to manage and administer pension and severance funds in Colombia.
Finally, Aval also has an interest in Corficolombiana, a merchant and investment bank, through both a direct stake and indirect ownership through Banco de Bogota and Banco de Occidente. Corficolombiana performs traditional investment banking activities, but also has significant investments in the real economy, primarily within energy and transportation infrastructure.
Grupo Aval current group and ownership structure. Source: Author.
The economics of these businesses have been quite good, with all four business segments regularly posting double-digit ROEs. Porvenir has averaged a 24% ROE since 2015, and taking into account write-downs for Corficolombiana during 2016-2017, it too has the potential to produce 20% plus returns on its equity base.
Since its size prohibits acquisitions in Colombian banking, the Central American group is likely to continue growing faster and is often an underappreciated part of Aval. Banking in Central America, like in Colombia, is typically oligopolistic and offers fantastic returns. On a normalized basis, presently, both Colombian and Central American banking are about a third of the profits of the group, with merchant and investment banking and asset management responsible for the remaining third.
Grupo Aval mix of net income and return on average equity (ROAE) from 2015 to 2020. Source: Author, derived from Grupo Aval financial filings.
The pandemic came late to Latin America compared to the rest of the world, but the region has been among the hardest hit. Colombia has performed better than regional peers on most statistical measures and, after cases peaked in the middle of August, has been declining at a relatively quick pace.
Colombia COVID-19 case counts and cumulative cases and deaths as a percentage of the population compared to other countries in the Americas (as of 9/7/2020). Source: Johns Hopkins Coronavirus Resource Center and author’s calculations.
But that progress against the virus came with perhaps the longest lockdown in the world, with much of the country only recently emerging from quarantines that began the last week of March. Now that that re-opening is taking place, attention can turn towards how quickly the economy can return to growth and whether the virus makes a comeback.
Unemployment for July exceeded 20%, and GDP is expected to shrink nearly 8% for all of 2020. Central American growth is expected to hold up much better, with the IMF only anticipating a 2% contraction of the economy in Panama and 3% of Costa Rica’s.
The economic upheaval has created earnings headwinds within three broad categories: net interest margin contractions as interest rates decline, reserve builds on loans, and the loss of fee income from lockdowns and a contraction in the economy.
During the second quarter, income from commissions and fees declined by 19% from the prior year, with much of the decline stemming from reduced ATM and credit card activity. This should mostly normalize with the economic re-opening.
Net interest margins should remain pressured well into next year, at least. Banco de la Republica, the Central Bank of Colombia, has lowered its reference rate to 2.0% from 4.25% a year ago. Many Central American countries have seen similar actions from their central banks. This does have the effect of lowering funding costs, but 35% of Aval’s Central American and 21% of its Colombian deposit base comes from checking accounts, which already have low funding costs. Another 46% and 33% of deposits, respectively, come from time deposits, which obviously will not reset immediately as short-term interest rates decline. Despite the 225 bps decrease in the reference rate for Colombia, funding costs declined by only about 60 bps year over year during Q2.
Meanwhile, the average effective interest rates on loans and investments have been crimped. Over the last year, ten-year Colombian government bonds have declined in yield by about 90 bps, from 5.9% to 5.0%, and yields on loans have fallen by close to a comparable amount. The net impact has been a net interest margin on loans of 6.0% so far in 2020 versus 6.4% in 2019.
Net interest margins are likely to remain under pressure before recovering. But they are not likely to get substantially worse from here. The Banco de la Republica, and central banks in Central America, are likely near the end of their cutting cycle, and funding costs should continue resetting in addition to loans repricing. Some relief programs have also had a small, negative impact on net interest margins.
What is of most concern to investors as the economies in the region begin to heal is how high reserves will need to grow in order to cover future losses. Estimating this can never be done with precision, but the task is made even more complex currently with the fact that so many borrowers have been placed on payment deferral programs, making their behavior as they come off them tougher to predict. In Colombia, 30% of Aval’s loan book went on a relief program and, as of the end of July, 18% remains on one. In Central America, where some governments mandated relief, 47% of the loan book was affected, and 22% remains on a relief program of some kind.
Reviewing high-level delinquency information for Aval gives the impression that at this point they may still be seriously under-reserved, given that relief programs have pushed delinquency rates lower, but the reserves its banks are carrying relative to delinquent loans are not significantly higher than what has been warranted historically.
Grupo Aval historical delinquency and reserve coverage. Source: Author, derived from Grupo Aval financial filings.
A couple of caveats are needed, however. One is that the acquisition this year of Multibank in Panama has distorted these figures somewhat since Multibank had already written down the value of its loans and Aval recorded them on their books at their fair value and not their gross value. Excluding the impact of Multibank, the overall reserve on the loan book stands at about 4.8% and the coverage ratio at 160%, with cost of risk and the rate of loans 90+ dpd not seriously affected. Additionally, reserves taken in past years for the Ruta del Sol project have also inflated some of the comparison ratios.
Compared to its most direct peer Bancolombia, Aval does more consumer lending, but that lending tends to be heavily weighted to secured categories such as payroll lending rather than unsecured ones like credit cards. As of the end of last year, 44% of Aval’s consumer lending book was comprised of payroll loans, with a good portion of those loans going to public sector employees. This compares to only 11% of Bancolombia’s consumer book in Colombia. Differences in composition help explain why over time Aval has tended to carry lower loss reserves and also why trying to directly compare reserving between the two banks is difficult.
It will be crucial to examine delinquency trends at the end of the third and fourth quarters as more customers come out of relief programs and have the opportunity to roll delinquent. While it should be expected that impairment losses will remain high through the beginning of next year before tapering off, it also seems likely that the company can absorb this impact through its net interest income and income from asset management and the real economy.
Modeling Forward Financials And Valuation
Putting together a base case for the company, then, involves estimating a net interest margin that should reach a nadir in the second half 2020, impairment costs that should remain elevated into next year, and non-interest income that should begin normalizing in the third quarter of this year as regional economies re-open.
To model Aval’s financials, I normalize the impacts of its main earnings contributors as a percent to assets. Using a bottoms-up approach, I currently estimate current year earnings of $0.39 per ADR, a decline of 53% from 2019, followed by $0.63 in 2021 and $0.83 in 2022. The two analysts who currently provide estimates for the ADRs are not too far off in their own estimates right now, averaging $0.45, $0.63, and $0.77 respectively for the years 2020-2022.
Grupo Aval financial model, 2015-2022 with historical P/E and P/B valuations. Source: Author.
While results could still deteriorate further from current estimates, it’s actually been pretty impressive so far the extent to which the company has been able to absorb the punches of the pandemic and maintain its dividend while continuing to build on its capital base. Again, while it’s still early to say with certainty when earnings might truly normalize, it is not unreasonable to think that, in 2022, earnings could again rise to 2019 levels.
That brings us to the important question of valuation. Aval has traded at an average of roughly 11x earnings and 1.4x book value over the past several years. If what might be considered “normalized” earnings were used (that is what was earned in 2019 and what we expect the bank to again be earning in 2022), then it would imply a $9 target at 11x earnings. Using 1.4x book value would imply a target of about $7.50. Averaging these targets together gives a value of $8.25. It certainly should not come as a surprise that Aval would currently trade for a discount, given near-term risks and a two-year runway to return to more normal profitability. The question is whether the 40% discount that shares trade at currently compared to a historical target price is justified? I do not think it is, given the historical stability of management, the diversity of Aval’s earnings streams, and the evidence that the worst of the pandemic’s impact on the real economies that Aval serves has passed.
Although it cannot be calculated with scientific precision, I think a discount of 15% is more reasonable, largely driven by the time value of money. That would put a target price on shares of $7, implying 42% upside to today’s price.
Keep in mind that Aval pays a pretty generous dividend, and the stock currently yields about 6.6%. So, if shares were to climb to $8.25 two years from now, the total return per year to shareholders would be close to 13% if shares were actually trading today at $7. That seems fair, given the risks to the outlook already discussed. At today’s price of $4.94 per ADR, normalization over the next two years would bring returns per year to above 35%. Granted, despite the high rate, it’s not a very long compounding period, but, investors are left with an excellent group of businesses and a fair valuation after two years if those assumptions play out.
Perhaps one more data point can help further illustrate Grupo Aval’s current undervaluation. Earnings this year have been depressed by nearly every imaginable definition. Yet, annualizing first half profits of $0.25 per ADR to $0.50 implies that the stock currently trades at less than 10x earnings, a discount to its longer-term average earnings multiple despite quite severely depressed net income so far this year.
Some of the biggest modeling risks have already been discussed at length, but at a high level, the shape of the recovery in Colombia and Central America is still yet to be fully determined. Losses in particular could come in higher than forecast, and net interest margins could remain depressed longer than anticipated.
The worst outcome for a bank in periods of stress is always insolvency or a large capital raise at unattractive prices. I actually think the risk of those scenarios for Aval is quite low. The company is 80% owned by the Sarmiento family and if there was any realistic chance of dilution or solvency problems, the company would have already suspended or reduced its dividend. The bank currently expects capital ratios at year’s end to be roughly what they are today, which is comfortably above the minimum capital standards set by Colombian regulators.
Not long before the pandemic, the company’s biggest risk was the resolution of legal inquiries into the Ruta del Sol project. That overhang appears to be resolving itself. In July, a recommendation was delivered by the Deputy Superintendent of Antitrust in Colombia to the Superintendent of Industry and Commerce recommending a dismissal of any criminal charges against the company and the payment of a fine, of which Aval’s share would be $18 million, for knowing of, but not participating in, a bribe. That fine would certainly be capable of being absorbed by the parent company, although the company continues to seek the dismissal of all charges against the company.
When discussing many countries in the emerging world, political risk is always present, and I always think it’s important to point out this risk in Colombia. The current President of the country, Ivan Duque, has two years left in his term before elections in 2022. Conservative politicians have held the Presidency for quite some time now and it appears that in 2022 voters will again be essentially choosing between a conservative, center-left, and liberal candidate for the Presidency. It is too soon to handicap the election outcomes, but if power should change hands, it could mean higher taxes on banks, perhaps the most profitable industry in the country, even if an outright leftist were not to be elected.
Finally, currency should be considered both a risk and an opportunity for investors. One U.S. dollar is currently worth about 3,700 Colombian pesos. The price of oil, Colombia’s biggest export, has the largest influence on the exchange rate, and investors should recognize that when they buy a Colombian bank, they are making an indirect bet on the price of oil.
If investors are looking for a stock whose fortunes are linked to recovering global growth and the potential for a COVID-19 vaccine next year, they should probably take a look at some value names in Latin America rather than some of the traditional travel names that might initially be considered.
Grupo Aval is one such name whose valuation has been crushed so far in the pandemic and which was not exactly expensive heading into this year to begin with. At a 40% discount to normalized valuations and a 6.6% dividend yield, Aval’s current price appears to be discounting quite a bit and seems to be a risk well worth taking, considering the company’s ability to thus far absorb the impacts of the pandemic and its history in generating consistent double-digit returns on equity.
Disclosure: I am/we are long AVAL, GIVSY. 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.