Markets are at a “profound crossroads”, according to Rob Burnett, manager of the £273.1m Neptune European Opportunities fund, who says now is a “wonderful moment to be a bank investor”. 
Financials have been among the hardest hit stocks since the financial crisis in 2008, with many investors nervous about re-investing in a sector beset by regulatory and structural challenges.
“It seems like there have been constant causes of stress from left-field for bank investors – litigation or capital, bad headlines, which have made investors very nervous about stepping into that because they think there is always going to be something else,” the FE Alpha Manager said.
This has been particularly startling in Europe, where the banking sector has underperformed the wider market by 79.59 percentage points over the past eight years.
Performance of indices over 8yrs
Source: FE Analytics
Burnett (pictured) said: “If we look at sector performance from 2007 to 2016, it’s actually been quite simple. To beat the market you needed to be very overweight staples and healthcare and you needed to be very underweight the banks.”
However, the sector has improved recently, and over the past six months the MSCI Europe/Banks sector has returned 19.72 per cent, 10.27 percentage points ahead of the wider MSCI Europe ex UK.
“But since the summer things have changed and the sectors that have been so profoundly strong have started to moderate and banks have started to improve,” he said.
The fund manager says the reason for the improvement has been a realisation by investors that interest rates cannot go any lower.
“We tried at the beginning of this year to have negative rates and it nearly killed the financial system, the banking system nearly failed because banks make money on the interest rate,” he said.
“During this period there has really only been one thing that has been profoundly hurting banks and it’s been falling interest rates.”
“Banks make money in net interest margins based on the price they charge for loans. As interest rates go down, bank margins go down. In this horrible period for banks there’s been one single enormously metric pushing the profitability of the sector down, pushing valuations down and pushing earnings down and that is falling interest rates.”
However, with interest rates unlikely to fall any further, he says, things are likely to start looking up.
“Bank profitability is stabilising, bank margins are bottoming,” he explained. “This is a wonderful moment to be a bank investor because you know that the attack that has been hurting the system, that has been holding these valuations down for such a long period of time is coming to an end.”
In the fund Burnett is overweight financials, with 36.85 per cent allocated to the sector including BNP Paribas and Banco Santander among its top 10 holdings.
This has led to a period of underperformance, particularly over a five-year timeframe where the Neptune European Opportunities lags both the IA Europe ex UK sector and MSCI Europe ex UK benchmark by 12.55 and 4.61 percentage points respectively.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
However, more recently the fund has outperformed and has been a top quartile performer over the past year and the strongest in the sector over the last six months.
“In terms of my fund – and this is why my fund had quite a good period recently but also why it’s had a tricky period over the last couple of years – we’ve had this overweight position in financials and banks – particularly European banks – and an underweight in the consumer staples,” he said.
However, the manager says an end to falling interest rates is not enough of a reason in itself to buy into banks, noting it is a “great starting point”.
What has given him conviction is the attractive dividends (and dividend covers) now being shown in the sector.
“The dividend yield this year, next year and the year after is actually the highest in Europe,” Burnett said.
“So the cash dividend we receive, in this world where income is so needed, is the best but importantly the pay-out ratio – that is the proportion of earnings the banks are paying to support the dividend - is the lowest by a long way.”
“The yield is the highest, the proportion of earnings required to support the dividend is the lowest so this is a phenomenal support for this investment. We know that the dividend can rise, irrespective of earnings growth, just by lifting the pay-out ratio.”
Closer to home, Schroders manager Nick Kirrage says now is a good time to be invested in the UK banking sector as well, despite a prolonged period of underperformance since the financial crisis.
Performance of indices over 8yrs
Source: FE Analytics
“Banks are the single most attractive sector in the entire planet,” he said, comparing the beaten-up sector to tobacco stocks which were out-of-favour in 2003 but have gone on to be one of the best performing sectors over the last decade,” said Kirrage.
“With [consumer] staples and tobacco everyone became obsessed with idea that there was a very negative downside to smoking and they were right about that. That has not changed yet tobacco [stocks] are up 1,000 per cent in 12 years.”
Instead, investors have focused on the other things that also haven’t changed including pricing power, the efficiency of the businesses, the low barriers to entry, and their great brands, he says.
“None of that was that different back then either, it was the price that allowed you to make a return,” said Kirrage.
“For banking, there are many complicated aspects to a bank but I think there are some very attractive attributes.”
“High Street banking in most markets in the world only four or five guys do it. In the UK you know its Lloyds, Natwest, Barclays etc. They do a huge slug of all the lending – corporate lending to companies and the personal lending mortgages all the rest of it - and it’s an oligopoly.
He says barriers to entry, customer loyalty and a cutback in competitiveness between banks following the crisis has meant they have similar fundamentals to the tobacco stocks.
Regulations put in place to make banks improve their balance sheets and de-risk have made them a safer investment than they were previously, he says.
“People talk about regulation as a headwind and I understand that; but you are missing a trick if you say that regulation stops shareholders returns.”
“It didn’t stop utilities going up hundreds of per cent in the 2000s and they’re the most regulated things on the planet.”
“The irony of that is I can think of very few sectors in the whole world that have been de-risking as aggressively and as continuously as banks since the last crisis.”
He added: “I can think of a few that did it for a few years and are now they’re issuing debt again, but banks every year reduce risk, shrink the balance sheet, get rid of the sovereign loans, raise capital, over and over: they’ve been forced into it.”
“As a shareholder that just means I have more safety and I think it would be a huge irony in the next downturn if banks turned out to be one of the more resilient places you could put your money rather than the most risky because they’re the only ones that have been preparing for it the whole time since the last crisis.”