Banking on growth in the EM financial services sector

Emerging markets financials have structurally stronger growth potential than developed markets
Conventional thinking argues that the case for investing in emerging markets (EM) equities is centered on economic growth. However, the Invesco Developing Markets team has focused on investing in globally advantaged businesses across the emerging world. We believe EM financials offer a distinct opportunity to apply our long-tested approach and invest in faster growing financial service franchises in the developing world.
In our view, there is clearly structural growth potential in underpenetrated credit, investment, insurance, and savings markets across the EM landscape. And in many EM markets, richer spreads and returns (see charts below) accompany stronger asset and earnings growth. This is a function of higher rates and more oligopolistic competition relative to the developed world.
Net interest margin (NIM) compares the amount of money a bank earns on interest bearing assets with the amount of interest it pays on interest bearing liabilities. Return on assets (RoA) measures the amount of profit a bank generates from total balance sheet assets.
However, not all financial service markets are equally attractive in the developing world.
Financial service markets are incredibly heterogeneous across the EM equity landscape. Broadly speaking, the more developed EM economies of Northeast Asia (Taiwan, South Korea), the Middle East and Eastern Europe have mature financial service penetration, which acts as a constraint on structural growth. And these geographies also have highly developed and competitive market topologies (banks and capital markets) which cap returns. These markets also generally have structurally low rates ala the developed economies of Europe, North America, and Japan.
This contrasts with attractive opportunities for growth and high through-the-cycle return potential in less developed financial service markets in Latin America, Southeast Asia, India, and certain markets in Africa.
Returns across the EM landscape are also widely diverse, reflective of both rates and market structures. Broadly speaking much of the “developed” part of EM (Northeast Asia, Middle East, Eastern Europe) has structurally low rates, reflective of mature levels of savings and disintermediation by capital markets. This contrasts with strong cyclically adjusted returns on assets (ROAA) in less developed markets in India, Latin America, and other lower income geographies. Oligopolistic market structures in these markets naturally lend themselves to strong net interest margins (NIMs) alongside solid growth potential. In many of these markets, private sector banks compete with stodgy public sector counterparts, which continue to lose share structurally. For example, Financial services company has tripled its lending share to 12% since 2005.1 Market concentration amongst the top five banks vary considerably (see table below), which amplifies credit and liability pricing power.
While many of the less developed economies are characterized by greater macroeconomic volatility, the long-term case for select EM banks is compelling as a result of superior growth, strong returns on equity, and extraordinarily sound capital structures.
Our philosophy of durable growth leads us to identify banks with strong balance sheet to ride the cycle. Our largest core financial holdings are concentrated in Indian banks and Asian insurance, both areas of durable structural growth. Our core bank exposure all have capital ratios which are significantly higher than regulatory requirements and their peers in EM. Very often this means they have the option to take market share – organically or through M&A – during uncertain periods.
The opportunities and pitfalls in the sector require an active approach
Given these potentially attractive opportunities, it is not surprising that the financial sector is among the top allocations in the MSCI Emerging Markets Index at 22% (source: MSCI, as of 3/31/22). While we like the growth and return potential of the financial sector - it is 21% of Invesco Developing Markets Fund (source: FactSet, as of 3/31/22) - our investment approach has led us to a very differentiated portfolio from the index.
The MSCI EM financial services sub-index benchmark is heavily populated with state-owned banks. We are reticent to invest in these businesses given obvious conflicts of interest with minority shareholders. Banks, by design, are capital intensive, cyclical businesses. Our highly concentrated investments in financial services are focused on companies that we believe have durable structural growth, sustainable advantage, strong risk management and governance. Our investments are also focused on financial service businesses that we believe have exceptional capital strength, both to fund growth and absorb periods of cyclical asset deterioration. In most cases, our investments are excessively capitalized against these needs, which implies considerable optionality in terms of both organic and non-organic growth potential. We also are interested exclusively in financial services that are investing offensively in omni-channel, digital capacities which we believe will emerge as significant competitive differentiators in terms of funding costs, efficiency and returns over the next few years.
Long-term investment case remains intact despite short-term volatility
While our financials holdings remain well-positioned for long-term earnings growth and market share gains, share performance has been uncharacteristically volatile over the pandemic period of the past few years. Our largest core financial holdings however are concentrated in Indian banks and Asian insurance, both areas of durable structural growth.
Footnotes
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1
Source: Reserve Bank of India