March was packed with good news for Ukraine’s economy. The month marked the nearly simultaneous end of the political, economic and meteorological winters in Ukraine.
After an 18-month period of sharply declining business activity, it seems we can state with confidence that the crisis is over, and that Ukraine’s economy is looking at brighter days ahead.
Companies all across the economic spectrum, from agriculture to steelmaking to transportation, are starting to report improved sales. Businesses are once again starting to speak about long-term modernization and capital investment. Yields on Ukrainian government bonds are down by a full three percent. The government recently predicted that gross domestic product will grow by 3.7 percent in 2010.
So as the logic of investor euphoria goes, in light of this tangible basis for optimism, the recent stunning rise in the value of Ukrainian equities is perfectly natural, right?
Even at the greatest of parties, there is always at least one sober person ready to chime in with a word of reason. This time around, those persons are us. We view the recent rise in the main Ukrainian equity indices, the UX and PFTS, of more than 60 percent year-to-date, as overreaction to the green shoots of recovery.
The discrepancy between share prices and fundamentals in the Ukrainian banking sector illustrates this point.
Ukrainian banking stocks have rallied by an average of almost 70 percent since the beginning of 2010. As “country risk” – the economic, political and business risks associated with investing in Ukraine – has diminished, investors have become more willing to purchase Ukrainian government debt, and the cost of insuring potential default of this debt has fallen. However, we believe that this factor of lowered risk has now been priced into the banking stocks, and that there are no other fundamental drivers to warrant further price appreciation at this time.
The major exchange-listed banks – Raiffeisen Bank Aval, Ukrsotsbank, and Bank Forum – will not show any significant profits until 2012, according to our estimates. The main problem with the banks’ bottom lines are that there has not been any real progress in the most troublesome issue: the large volume of non-performing loans. The majority of these bad loans are still parked on the banks’ balance sheets. Writing them off or selling them to third party collectors at a loss will eat away most, if not all, of any profitability in 2010-11.
Equity investors have so far shrugged off the poor Ukrainian banking profitability outlook during their recent buying spree. A quick comparison of the trading multiples of Raiffeisen Bank Aval and its parent company, Austria’s Raiffeisen International Bank Holding, reveals a rather telling irony regarding the two banks’ respective valuations. Based on price-to-assets and price-to-book ratios, our local Raiffeisen subsidiary is three to four times more expensive than its parent. However, the relatively low value of Raiffeisen International is partly or even primarily due to international investors’ concerns about the impact of Raiffeisen Aval’s problems on the bottom line of its parent company – an interesting twist of investors’ risk profiles.
Further, if we compare the Ukrainian banks’ trading multiples with those of selected peer banks in Eastern Europe, such as Poland’s BRE Bank and Bank Pekao, we have no choice but to conclude that the exchange-listed Ukrainian banks are overvalued at their current pricing levels. The projected 2010-2011 price-to-earnings ratios for each of the three banks in our analysis are either negative or meaninglessly high. With an average 2010-2011 price-to-book ratio of 3.0, the Ukrainian banks are simply not attractive buys compared to their peers.
We also take a cautious view in our outlook for the future lending activity of Raiffeisen Bank Aval, Ukrsotsbank and Bank Forum in the medium term. These three banks are subsidiaries of Western institutions and, as they work their way out of the current downturn, they have introduced risk management policies in compliance with those of their parent companies. Therefore, we expect these banks to lend more conservatively than their locally owned peers, Privatbank, UkrEximBank, and Oschadny Bank, as well as the Russian-owned Prominvestbank and Sberbank Rossii.
As such, the loan books of Ukraine’s major exchange-listed banks are likely to see relatively slower growth than the overall loan market in 2010 and 2011. Naturally, even a gradual resumption of lending to corporate and retail clients, which we expect to see over the next 18 months, will be a welcome development for businesses.
Our analysis of the banking sector stocks can also be applied to the other major segments of the equity markets – steel, power generation, mining and agriculture. Companies in each of these sectors have seen precipitous short-term rises in their stock prices with little relation to the minor improvements on their balance sheets.
This does not mean that we take a pessimistic view of the overall Ukrainian economic situation. Sustained appreciation in stock values is nearly always based on sound long-term economic fundamentals – and for Ukraine, these fundamentals are increasingly strong. Nor does it mean that these stocks cannot rally further, as there are many factors other than the fundamentals of the underlying business that lead investors to drive a company’s stock price higher.
But even in the hottest of emerging markets, real economic growth occurs over years, not months. We believe investors would do well to keep the enormous gains of early 2010 in the proper perspective. That is, your sober friend will let you enjoy the party while it lasts, but he’d hate to see you and your portfolio sleeping on the couch well after the smart money made it home.
Volodymyr Dinul is head of research and Will Ritter is research editor at Sincome Capital Group, one of the leading brokerage companies in Ukraine. They can be reached at firstname.lastname@example.org and email@example.com