UK and European banks are offering “once in a lifetime” opportunities given their bottom-up fundamentals and low valuations, according to SVM’s Hugh Cuthbert, whiles Architas’ Adrian Lowcock believes the sector’s well-known headwinds are beginning to fade. 
However, FE Alpha Manager Neil Woodford (pictured) – alongside the two aforementioned industry professionals – believes there are significant disparities between individual stocks and, as such, in-depth bottom-up research must be implemented.
This comes following a recent bounce-back in developed market bank stocks, which was bolstered by the belief that fiscal expansion will boost growth and encourage interest rate rises from central banks.
While banks have historically thrived under such conditions and many are trading on cheap valuations, some investors remain sceptical following issues surrounding opacity and tight regulations.
Performance of index since start of FE data
Source: FE Analytics
Despite these widespread fears, Cuthbert – who co-manages the SVM All Europe and SVM Continental Europe funds – is seeing a wealth of opportunities in the sector. In his five crown-rated continental European fund, for instance, he holds 35.82 per cent in financials and, in his four crown-rated SVM All Europe fund (which has 68 per cent in UK stocks), he has a 25.61 per cent weighting in the sector.
“I have held banks for a long time. I think this has been and still remains almost a once in a lifetime opportunity actually. In a lot of cases, we have made very good money already because our investments have never been predicated on risk,” he explained.
“If you look at what we currently have and have held in terms of banks, in the majority of cases their capital has been sufficient even in an onerous capital environment.
“Therefore, that tail risk was less in terms of the fact we believe we picked the ones that were and are the survivors.”
The manager says there are three major headwinds investors need to watch out for when investing in the sector; regulation, top-line growth and the amount of capital they hold.
A general improvement across all three of these factors, combined with the fact he believes sector risk is more than priced into valuations, means Cuthbert is hugely positive on banks.
“I don’t do macroeconomics, but interest rates on average have been considerably higher than they are today and I don’t in any circumstance envisage that we will continue with negative to 0.25 basis point rates for the rest of my investment career,” he continued.
“I don’t know when this change in the yield curve will come but, when we first bought into these banks, I decided that it was worth waiting when you’re only paying half price-to-book ratio.
“That’s what we did. Everybody told me at the time that we’re in deflation and that we’re in a Japanese environment, we’re all doomed, interest rates will never move again. But my heart of hearts always told me that, at some point, they will start to normalise.
“We’re starting to see that now. Whether it’s sustainable or not I don’t know, but it’s another part of the story falling into place as well. Less capital, more top line, less regulation and less than one times book equals a great investment opportunity. We like banks from that perspective and that’s why we’re overweight.”
Star manager Woodford, who runs the £9.6bn Woodford Equity Income fund, is well-known for exercising caution on the banking sector over the years, having sold out of the sector completely several years before the 2008 crisis.
More than a decade later, he dipped his toe back into the water and added HSBC to his portfolio, although this was removed a year later in 2014 due to regulatory concerns.
“I’ve said for a long time that in the wake of a systemic crisis, you should look at banks as investment propositions only when they are doing the things you would expect a repaired bank to do,” he said.
“So you would never, ever listen to what a regulator tells you about the health of a bank’s balance sheet or indeed what the chief executive tells you about the health of bank’s balance sheet.
“They are in business to tell you that they are solvent and liquid, even when they’re not. Ignore stress tests, you name it – the fact is the regulator has a vested interest in ensuring that everyone retains a level of confidence in the banking system.”
For instance, Woodford points out that, seven years ago, Lloyd’s chairman announced the bank had a strong balance sheet and was in the process of being overhauled.
The bank’s share price was 70p at the time and, during the interim period, it fell to just 25p per share.
“The situation now is somewhat different. The thing that I would look for from a repaired bank is credit growth,” the manager continued.
“When the banking system is seeing credit growth, I think what we are witnessing is banks that are repaired – particularly when they are lending to business rather than to people buying houses.
“My view is US banks were the first to be repaired and UK banks were next to be repaired – I think they are broadly now repaired – and European banks are far from repaired.”
In terms of whether they are good investments from here, Woodford says it depends on the individual stock, whether it is solvent and whether it has adequate capital.
From this, their ability to grow profits, earn attractive returns and grow dividends must also be considered.
“HSBC, for example, had some pretty poor results the other day – it missed on revenue, it’s earning 3-4 per cent on capital, its cost of capital is probably something like 7-8 per cent and it’s rated at 1.3x book value. I don’t think that’s very attractive,” he continued.
Performance of stock over 1month
Source: FE Analytics
“What a bank like that needs to do to become attractive from my point of view is to transform its returns and I don’t think there is much on the horizon that can do that.”
Adrian Lowcock, investment director at Architas, agrees with Cuthbert and Woodford that post-crisis headwinds such as bad loans, fines, increased legislation and scandal-related compensation pay-outs are fading over time.
He also says that, because the UK’s economic outlook is improving, more people are able to pay interest on their loans and non-performing loans are therefore at low levels.
“In addition, the gilt curve, which shows the change in yield across gilts with different lengths of maturity, has been steepening since the Bank of England cut interest rates in August,” Lowcock said. “This is good news for banks because they tend to borrow money in the short term, where yields are cheaper and lend for the longer term where rates are higher.”
That said, he warns there are still risks with investing in financials, given there has been some profit taking in the sector due its strong outperformance in the second half of 2016.
He also points out that, if economic growth disappoints relative to expectations and regulatory reform fails to materialise, banks could struggle.
Lowcock therefore believes investors should be selective when to comes to picking funds with exposure to banks, and currently favours Jupiter Financial Opportunities, JPM US Equity Income and Majedie UK Equity.
“[Majedie UK Equity] is run by five managers, each individual is responsible for their own section of the funds,” the investment director said.
“They share a core philosophy to be pragmatic and flexible, and as such they seek to buy shares with the highest upside potential. There is a focus on valuation gap and the fund has targeted deep value sectors of the markets.
“In recent years the themes in the fund have been banks, oil & gas and miners which they started to buy into last year, albeit early. These sectors could benefit from the expected fiscal stimulus programme resulting from the election of President Trump and which is expected to spread across developed markets. The fund currently holds 17 per cent in banks.”
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
The four crown-rated Majedie UK Equity fund, which is in the top quartile for its returns over one, five and 10 years, has a clean ongoing charges figure of 0.77 per cent and yields 2.32 per cent.