A required shift in Investment Analysis

Traditional value analysis of equity investment assumes a fair amount of stability in the business environment and compares the analysed value of an enterprise to the market price with the aim of establishing value, or lack thereof. We can also refer to this as a “static” valuation approach where the business and industry conditions are assumed to remain fairly constant over a prolonged period. The alternative is a growth or dynamic value approach where more relevance is given to the enterprises ability to grow into, and beyond market valuation.

Technological advances in all industries are resulting in a continually fast-changing business environment, which is true to varying degrees for most industries. It intuitively should therefore increase the emphasis on a dynamic growth evaluation technique. In a fast-changing environment distinguishing between potential winners and losers requires a marked adjusted approach.

Analysis techniques that assume static industry and company parameters are bound to be less effective. An important goal now is to identify businesses that are correctly positioned and have the   capacity, as well as the willingness to adapt timely and correctly. The result is that:

• Historical performance (via annual financial statements and updates) will always be central to analyzing, but become somewhat less important. History will only be a moderate indicator of future success.
• Qualitative factors that point to a companies’  adaptability, positioning and capabilities will become more relevant.

An adaptive valuation model might rely more heavily on qualitative principles:

1. A conceptual ability and willingness by management to adapt and change.  Annual financial comments, ongoing updates, meaningful adjustment to the business plan, as well as investments in the right areas.
2. Volatile and fluid business conditions will place a premium on quality management.
3. Structural and regulatory barriers to disruption will be an important industry level assessment.
4. The cost and effort of adapting and competing with disruptors and disruptor technology.
5. The inherent advantages and disadvantages of being an established industry participant business.
6. Applying and redeploying current assets effectively.

A.  An example: SA Banking Industry
Global traditional banking model is under investor scrutiny as a result of the growing technological disruptor risk. This is no less true for SA banks where virtual banking, efficient new systems and fleet footed lenders are making the physical branch system, legacy systems and large workforce a drain on earnings. New entrants have an immediate benefit in all these areas. Investors, as a result has tended to downgrade their perception of large commercial banks earnings potential. But is the outlook as negative?– only if we take a static snapshot of the situation. A better view might be to filter the information through a more dynamic adaptive model

1.  Ability and willingness to change:
Standard Bank has closed 92 branches in 2019, which the other banks (Nedbank) have been embarking on without official announcements. It could be argued that it is too little too late, but it does indicate the willingness of adapting, even if it is an unpopular decision amongst unions and politicians.

2. Quality and adaptive management will be seen over time in the actions taken

3. Structural and Regulatory barriers.
The banking industry is highly regulated globally. Although lenders and new banking participants can enter at the margin, they will face the same regulatory burden and costs. Established players are cost effective and efficient in this area.

4. Legacy bank systems are estimated to be doubly as costly and ineffective as new entrant system.
The economic impact of changing is, however not cumbersome.

5. Established players have a fairly sticky client base and relationships as a result of trust and convenience.
It is easier to keep clients than to gain them. Capitec, has however proofed that market share can be gained by a low cost, value offering. New entrants should be able to gain traction with a low cost, convenient offering.
Large established players have an efficient funding system at preferential rates that new lenders and even banks will have to institute.

6. Adjusting assets efficiently:
Established banks can greatly increase competitiveness by changing their business models where they have a competitive edge.

a.   Utilizing big data effectively:   
The detailed and informative data that banks possess is extremely valuable.  This can be used to establish exact risk profile on clients to be competitive and lower the risk on the loan book. Selling beneficial insurance and related products (if permitted) can both retain clients and increase earnings. Relating data to that of retail businesses can be mutually beneficial. New entrants cannot compete.

b. Investing in new technology and related private equity.
Access to low cost capital and risk management systems/expertise can be used to build up a portfolio offinancial and other technology ventures. Established banks have data access on these clients, giving them a competitive edge even on asset managers.  Eg. Nedbank has been investing in various technologies for a few years.

c. Restructuring branch network.
A small, but optimally used branch network could become a competitive edge. Capitec uses its extensive branch network already to sell related products like funeral policies etc, whilst most banks have Government departments operating form its branch premises. The secure and trustworthy nature of a branch can be used to offer a wide variety of related products and services (insurance, investments, airtime, safekeeping, central delivery….)

Summary – Change is not optional:
The banking industry and established players can remain relevant and competitive if they are willing to adapt. Like in any industry there will be change, winners and losers. Banks can remain successful if they are willing and able to adjust their business plan.

How might a future bank be profitable  and competitive?
Employing big data, access to capital, risk management capabilities and physical assets in new and innovative ways to retain clients, widen the product range and create access to new technologies. A bank, insurer, asset manager, retailer…. in one!