Secrets from the vault: How we invest in EM banks

The right banks can provide strong, sustained performance, but finding them requires imagination.

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, through the Invesco Oppenheimer Developing Markets Fund, is guided by four core philosophies, which we discuss below.

1. Market structures matter enormously

A concentrated market structure may give banks pricing power, allowing them to possibly generate consistent 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 return on assets (ROAs). Figure 1.

Few banks in the world operate in such attractive market structures as Russia and Peru, where the two countries leading banks, Sberbank and Credicorp, respectively, control between 30% and 50% of the deposits and assets in the banking system1. 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 sustainable, superior ROAs of 2.0% to 2.5%2.

Figure 1: EM banks had materially higher ROAs

Source: HSBC Research based on the banks under their coverage. Most recent data available. Past performance is no guarantee of future results.

2. Long-term and durable growth may lay the foundation for multi-year compounding stories

It will surprise no one that banking sectors in emerging markets have relatively low penetration rates that may provide 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 27% of GDP3, respectively, as of August 2019. COMI’s loan-to-deposit ratio was only 40.4% in Q3 20194, 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. Figure 2. Kotak’s underleveraged balance sheet (Tier 1 ratio of 18.7% in the second quarter of fiscal year 2020, the highest among its peers5) may allow it to fund its loan growth for several years to come. 

Figure 2: Indian private banks have been outgrowing their public peers
Total credit in the Indian banking sector, excluding non-banking financial company (Trillion Indian Rupee)

Sources: IFFL (2018), Company filings (2018). FY stands for Full Year

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 potential result is 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 potential 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) has migrated 71% of customers onto the digital channels in 20186, 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).

In a typically 10x leverage business, errors of commission prove far more expensive than errors of omission. Therefore, we don’t concern ourselves with low-quality circumstances.

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. Figure 3.

Figure 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.

Leo Tolstoy, the famous Russian author, 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 some may think that 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 may start to loosen their underwriting standards and accumulate loans which may never be paid back. Sooner or later, the banks may 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 (about 12-13x for big banks7). To put it another way, if investors miscalculate the true loss on the banks’ assets by just 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 current holdings

Our two largest positions are both Indian companies: HDFC Ltd and Kotak Mahindra Bank. These are the highest quality financial institutions in India, in our opinion, 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. In our view, 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.

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

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


1. Source: Sberbank and Credicorp quarterly filings in Q3 2019

2. Source: Sberbank and Credicorp quarterly filings in Q3 2019

3. Source: COMI Investor Presentation in Q3 2019

4. Source: COMI Investor Presentation in Q3 2019

5. Source: Company results presentation in Q2 FY2020 (Sept 2019). Data are at the consolidated level.

6. Source: FirstRand results presentation in H1 FY2019 (December 2018)

7. Source: Company filings as of Q3 2019

Important Information

Blog Header Image: Credit: Maksim Ozerov / Getty

As of 9/30,19, HDFC Ltd represented 3.50% of Invesco Oppenheimer Developing Markets Fund holdings, Kotak Mahindra Bank, 3.35%. Sberbank 0.52%, FirstRand, 2.00%, Credicorp, 1.91%. Commercial International Bank Egypt (COMI), 0.54. It should not be assumed that an investment in the securities identified was or will be profitable. Companies listed are not buy/sell recommendations

Net interest margin is a measure of the difference between the interest income generated and the amount of interest paid, relative to the amount of their interest-earning assets.

Return on assets is an indicator of how profitable a company is relative to its total assets.

Loan to deposit ratio is the ratio of a bank’s outstanding loans for a period to its total deposit balance over the same period.

Cost of equity is the return a company requires to decide if an investment meets capital return requirements.

The Gordon Growth Model, also known as a version of the dividend discount model (DDM), is a method for calculating the intrinsic value of a stock, exclusive of current market conditions. The model equates this value to the present value of a stock’s future dividends.

Price-to-book is a ratio that compares a company’s current market price to its book value;

Price-to-equity is a ratio that compares a company’s share price to the earnings per share.

Dividend yield is the dividend per share divided by the price per share.

The opinions referenced above are those of the authors. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

The mention of specific countries, industries, securities, issuers or sectors does not constitute a recommendation on behalf of any fund or Invesco.

An investment in emerging market countries carries greater risks compared to more developed economies.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the Fund.

Justin Leverenz, Team Leader and Senior Portfolio Manager

Justin Leverenz is a Team Leader and Senior Portfolio Manager for the OFI Emerging Markets Equity team at Invesco.

Mr. Leverenz joined Invesco when the firm combined with OppenheimerFunds in 2019. He joined OppenheimerFunds in 2004 as a senior research analyst. Prior to joining OppenheimerFunds, Mr. Leverenz was the director of Pan-Asian technology research for Goldman Sachs in Asia, where he covered technology companies throughout the region. He also served as head of equity research in Taiwan for Barclays de Zoete Wedd (now Credit Suisse) and as a portfolio manager for Martin Currie Investment Managers in Scotland. He is fluent in Mandarin Chinese and worked for over 10 years in the greater China region.

Mr. Leverenz earned a BA degree in Chinese studies and political economy and an MA in international economics from the University of California. He is a Chartered Financial Analyst® (CFA) charterholder.


Tan Nguyen is a Senior Research Analyst for the OFI Emerging Markets Equity team at Invesco.

Mr. Nguyen joined Invesco when the firm combined with OppenheimerFunds in 2019. He joined OppenheimerFunds in 2012 from Bain & Company, where he was an associate consultant conducting due diligence on a variety of industries, including consumer goods, computer software and hardware, and industrial goods and services. Mr. Nguyen has also done research on the competitive landscape and market evolution in the technology, media, and telecommunications sectors and has expertise in financial modeling. Prior to Bain & Company, he was a teaching assistant at Brown University for three years in mathematics and finance.

Mr. Nguyen earned a concurrent undergraduate degree in mathematics-economics and an MA degree in economics from Brown University.

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