What Happens In Hated Markets

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As I told you a few days ago, In December 2013, Kazakhstan was ignored by most investors. The country was facing political uncertainty, government corruption and it was a world leader in banking sector non-performing loans.

Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

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On the surface, this sounds terrible. But this type of setup is – potentially – a contrarian investor’s dream. That’s why I found it interesting.

The fact that there was such widespread concern about the future of Kazakhstan meant that in late 2013, it was all “priced into the market.” In other words, investors were already assuming the worst. So anything but the worst would be good for Kazakhstan.

It seemed to me that Kazakhstan, and its banking sector, was a great setup for an out-of-favour investment… (in case you missed it, I explained the setup here).

Betting on Kazakhstan’s largest – and cheapest – bank

In 2013, Kazakhstan had the highest level of non-performing loans (NPLs) of any banking sector in the world.

Investors use NPL levels like doctors use blood pressure readings… it’s a key barometer of the overall health of the banking system and, by extension, the economy. Kazakhstan’s NPL levels suggested the country’s banking sector and economy should have been on life support – if not six feet under.

The country’s largest bank (based on assets), Kazkommertsbank, had nearly one-third of its loans overdue.

KKB serves retail and corporate customers across Kazakhstan and the region. In 2013, about half of its US$19 billion loan book was extended to the real estate and construction industries (and just 14 percent to individuals).

The post-global financial crisis devastation of the Kazakh real estate sector helped explain why so many of its loans were overdue. While Kazakhstan wasn’t alone in having a damaged and bloodied banking sector, its NPL levels were absurdly high compared with banks in pretty much any other part of the world.

So you can understand why investors didn’t want anything to do with the bank. But in 2013, KKB was taking all the right steps to improve its business and bottom line.

For a few years after the global economic crisis, KKB largely stopped lending money so it could focus on getting as much value out of its overdue loans as possible. It started taking stakes in projects with long overdue loans, and making additional loans to see projects to the end… where it could finally realise some value.

These sorts of recoveries take time – and finding a buyer for a completed project can take even longer. The process was slowed even further by the corruption, inefficiency and immaturity of the Kazakh legal system, which was still learning how to deal with the intricacies of asset foreclosure.

Results were slow… but steady.

This made the stock absurdly cheap in December 2013, trading at a forward price-to-book (P/B) ratio of 0.3… compared with the average P/B level of around 1 for most banks. This means that you were paying 30 cents for every US$1 of capital on KKB’s balance sheet.

That price reflected investor expectations that a whole lot was still going to go wrong for KKB… or rather, that KKB was completely off the radar. Investors didn’t want to touch a toxic Kazakh bank.

But how bad could it really be? I believed that the shares wouldn’t be this cheap forever… thanks to a number of powerful and underappreciated catalysts.

Things were about to turn around for KKB

First, NPLs were at the top of the central bank’s agenda. They wanted to make it easier for banks to clean up their balance sheets.

Second, KKB was doing the right thing by working to maximise value from its overdue loans. The CEO of a competitor, who, if anything, would prefer to see KKB fail, told me (during a chat in his office when I was in town) that he was very impressed with the approach of KKB management.

There was a cushion, too… KKB had US$1.5 billion in cash on its balance sheet. And it had a solid capital adequacy ratio (a way to measure the balance between a bank’s capital, and the amount of risk it takes on).

Finally, there was already a success story in the Kazakh banking sector… which suggested that investors may begin to notice KKB soon. Investors had been focused on Halyk Bank, the other big publicly traded Kazakh bank. Halyk had announced strong quarterly results and promising underlying growth. And its shares had been rising steadily for months – outperforming shares of KKB. This was a good sign that investors would be willing to invest in KKB as its outlook improved.

The company faced a lot of challenges, though.

First, the government held a 21 percent stake in KKB, which was scheduled to go up for sale in 2014 – and no one knew who might buy it. That meant there was a risk of someone buying who didn’t have small shareholders’ best interests in mind.

However, I thought that this risk was limited. The European Bank for Reconstruction and Development (EBRD), a developmental lender throughout Eastern Europe and Central Asia, held a 10 percent stake in KKB. The EBRD had a lot of pull with Kazakhstan’s government, and one of its main focuses was on protecting the rights of small shareholders. So I thought the risk to small shareholders was overstated.

Second, I knew KKB’s loans portfolio and earnings wouldn’t start growing significantly until it resolved its NPL problem. And any weakness in the Kazakh real estate market could also hinder KKB’s efforts to restructure its loans. But my analysis suggested that KKB shares were so dirt cheap that all of this was already reflected in the share price… and then some.

So, I recommended KKB shares to the subscribers of an investment service I was writing at the time.

A few months after my recommendation, the Kazakh banking sector began to stabilise. New legislation called on banks to bring down their NPLs to 15 percent by the end of 2014 and 10 percent by the end of 2015. To help banks achieve these results, the government amended the tax code to make it easier for banks to write off loans. Stabilising prices in the real estate market also meant that banks could move bad loans off their books.

And KKB ended up buying rival BTA Bank. Investors saw this as positive news… it made the combined entity the largest banking group in Kazakhstan, which the government couldn’t afford to let fail.

Within a year of my recommendation, other investors started to see the potential in KKB… and we ended up locking in a 137 percent return in just seven months.

There are lots of KKBs

These are the types of gains that are possible when you look far and wide for investment opportunities. And great opportunities appear in all sorts of circumstances, markets and environments.

These opportunities are around us all the time. Maybe it’s an economic crisis, or financial mismanagement or political problems. A country’s currency might be under fire… the market might be facing an economic slowdown… investors might be fleeing because of a massive corruption scandal… a country’s economy that is dependent on commodities might be hurting when commodity prices take a dive… or perhaps the world’s central banks are reducing the growth of money in the entire global market environment, hurting investor sentiment far and wide. There are lots of reasons that a particular sector, market or stock might have fallen out of favour.

Remember, markets (and investors) don’t always behave rationally… and that’s where the real opportunities are.

Good investing,

Kim Iskyan

Editor, International Capitalist

Stansberry Churchouse

P.S. It’s to find high-upside opportunities like KKB that I launched International Capitalist. I look all over the world for attractive investment opportunities like Kazakhstan in 2013… with the potential for big – and even life-changing – profits. For a limited time, we’ve opened International Capitalist to new subscribers… you can learn more about it here.

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