James Sullivan‘Following the herd’. ‘Being an ostrich’. ‘Looking in the rear-view mirror’, or ‘simply not understanding…’ That’s a pretty negative start to an article!

In most cases, all of the above apply when either financials or banks are mentioned. The 9th of March 2019 marked 10 years from the post-crisis valuation lows for the US, European and UK banks, with the world’s largest sector – around 17% of global market capitalisation – still  largely shunned by investors. We therefore decided to look in detail at what has happened over the past decade, where are we today and what the potential is from a deeply contrarian call.

Around 65% of the financial sector is represented by banks. This is a large, broad and diverse global sector offering many opportunities outside the UK problem children and the deeply troubled Italian banks. The vast majority, encouraged by regulations/authorities, have considerably recapitalised, reduced risk and reined in their lending books. The result is that banks are generating excess, unrequired cash and returning capital via increasing dividends and share buybacks. Yet banks’ valuations are pretty close to the levels that they traded at 10 years ago and, even if we are in a slowdown, multiples of 9x with elements of utility stocks seem attractive. So, looking forward rather than back, maybe the real risk takers have been the bond markets and equity investors?

The team behind Polar Capital Financials Trust (PCFT) have long track records in many areas of the financials space. PCFT is a softer play on the sector with an old fashioned income and growth approach.  We’re very comfortable with this investment style, as there seems to be many exciting opportunities with strong potential without needing to turn the risk dial up. The Trust’s prospective dividend is around 3.3% and it has grown by an average of 7% pa. PCFT is 85% non UK and well diversified; the modest domestic element is much more about niche investments than household names. In addition to the global banks, the team looks at investments in life and non-life insurance companies, asset managers, stock exchanges, speciality lenders and fintech. They have freedom to allocate as they see fit to the various sub-sectors depending on the current outlook or, where applicable, timing of the respective cycle; holdings are in large, medium and small companies. They currently have one unquoted investment in Atom Bank but could have more.

With regards to the considerable excitement around fintech, the team is deeply knowledgeable and take a level-headed approach. They do have 6% in pure fintech exposure however, having the ability to spot companies that are changing/embracing new models in the established quoted space, should be very lucrative and avoids venturing in to untested, high risk start-ups. They look for reality over speculation; the banking old guard are not rolling over and many have considerable, exciting fintech strategies underway. In addition, we can purchase PCFT at a discount of around 5% to its underlying NAV. An impending corporate action that will enable investors to cash out at NAV within the next twelve months offers an attractive boost to returns.

Finally, this sector should not be viewed as a binary call on rising or falling interest rates. It has changed considerably over the past decade and is close to historical valuation lows, has restructured balance sheets and is embracing new technology while offering interesting, growing income streams. The divergence between growth and value stocks is extreme and markets have buried their heads in the sand when it comes to steady and boring. Therefore, one of the biggest risks for investors is neither owning nor understanding the market’s biggest investable sector.

Download: Weekly comment, James Sullivan – 290419

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