Investors who are unsure of where to find value in the current expensive and increasingly volatile market could do much worse than follow the example of “the smartest guy in the room” and put 40 per cent of their portfolio in financials.
This is according to Nick Brind, co-manager of the Polar Capital Global Financials Trust. Brind pointed out that in a market where value is scarce, banks in the US are trading on about 9.5x 2020 earnings, banks in the UK, Europe and Japan are at about 7-8x 2020 earnings and banks in emerging markets are on “anything from 5-15x” 2020 earnings.
Brind said that while at these levels, the market appears to be pricing in a recession, he believes the sector will make it through such an event in much better shape than is expected – and this is assuming there even is a recession.
“If there isn’t, the sector is incredibly cheap,” he added. “And you could tongue in cheek say the smartest investor in the room is 87 – 88 in March – Warren Buffett. And 40 per cent of his investment portfolio is in financials, so he added another $15bn to his holdings in the second half of last year.
“And if the smartest guy in the room thinks they are a good bet, who are we to know better?”
Berkshire Hathaway top-15 holdings
Source: Berkshire Hathaway
The Polar Capital Global Financials Trust was launched in July 2013 with the aim of allowing investors to play the recovery in the sector following the financial crisis. In a bid to reduce concentration risk, exposure to the UK is limited to 10 per cent of the portfolio, as the vast majority of shareholders are wealth managers, whose clients are already likely to have significant holdings in FTSE-listed financials
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The trust’s stockpicking process has a heavy focus on risk, with co-manager John Yakas (pictured) saying the way to make money from financials over the long term is by limiting the downside.
“The important thing with banks is that they are incredibly highly geared,” he explained. “Think about it: you have these huge asset bases sitting on relatively small amounts of capital.
“In reality you can grow a loan book dramatically, so you have two or three years of great growth, then suddenly the quality of what you valued comes home to roost and you end up having problems.
“Actually, limiting your downside tends to be more important than worrying about your upside, basically. That underpins the whole process.
“So from the beginning there is a kind of quality bias. The starting point is trying to assess the balance sheet and you are looking at capital funding, loan books, and you are going back and you are going forwards because it is cyclical.”
Despite this focus on balance sheets and risk, the managers say the nature of the sector means they can still get it wrong. They pointed to the example of Swedbank, which they described as an example of “an incredibly well-managed bank”, which has lost close to a quarter of its value over the past week on fears that it has been involved with money laundering.
Brind said the problems originated from Denmark’s largest bank, Danske Bank.
“Danske Bank had an issue where significant flows of money came through its Estonian branch from non-resident entities and its share price has roughly halved on concerns there will be a large fine,” he explained.
“And the issue with Danske Bank was there was a whistle-blower – a British chap – and it looks like management didn’t pick up on that. And that’s drawn in suspicion on some of the other Scandinavian banks, those other banks that facilitated Danske. They are rumoured to be Deutsche and two of the other big banks.
“So there was a documentary out last week suggesting that Swedbank has suffered from money laundering. Obviously a much smaller amount than Danske. But it is very difficult for them.
“They have said, ‘look, whenever there has been a question mark, we have reported it to police’. But with money laundering you have to be very careful about what you say publicly. That has been quite rare for us.”
Another major headwind for the sector is the low interest-rate environment. John Pattullo, manager of the Janus Henderson Strategic Bond fund, has long warned of disinflationary pressures from the “Japanification” – ageing demographics and changing behaviours in response to a financial crisis – and “Amazonisation” – which makes it difficult to get any pricing power – of global markets, which are likely to supress interest rates over the long term.
However, Yakas said that the cost controls implemented by banks since the financial crisis should continue to drive returns higher over the next decade.
“We as customers are changing our behaviour so there is no need to have all these branches,” he added.
“Despite what the press likes to say, in reality there is a huge shift in transactions going on, digital, and phone banking is actually the thing that is really taking off. And that is why ATM networks are not needed, the volumes going through are just not the same as they were.”
And while these cost savings have yet to be reflected in returns, Yakas believes this is soon likely to change.
“You had this environment where you had this huge growth in compliance costs and regulatory costs and so on and that has essentially come to an end.
“We agree with the notion that the cyclicality of interest rates is probably going to be a lot more flat. But I think most management teams we have come across are aware of that,” he finished.
Polar Capital Global Financials has made 46.44 per cent since launch, compared with gains of 58.6 per cent from the IT Financials sector.
Performance of trust vs sector since launch
Source: FE Analytics
However, data from FE Analytics going back to October 2000 shows FE Alpha Manager Yakas has made more than twice the gains of his peer group composite over this time.
Performance of manager vs peer group composite since Oct 2000
Source: FE Analytics
Polar Capital Global Financials is yielding 3.22 per cent and has ongoing charges of 0.99 per cent. It is on a discount of 5.08 per cent to net asset value (NAV) compared with 4.54 and 6.49 per cent from its one- and three-year averages. It is 2 per cent geared.