Kartik Kumar has added Lloyds to his Artemis Alpha Trust on recent share price weakness, saying the rest of the market is being “myopic” in its view of what the bank will look like when it emerges from the other side of the coronavirus crisis.
Artemis Alpha is down more than 20 per cent this year – in line with its peers and the rest of the market – and Kumar admitted that although he was cognisant of the risk that was building in markets in February, he was too slow to react, referring to himself as “like a dinosaur when the meteorite hit”.
Performance of fund vs sector and index in 2020
Source: FE Analytics
However, he said the severity of the fall in certain areas of the market has created significant opportunities to add value in the future.
“If a security was worth 100p in January and it is now trading at 50p, what I’m trying to do is work out how much damage the virus is inflicting in the short run and what that does to the business’s value once it returns to normal,” the manager explained.
“When you put those two factors together, you can start making judgements, saying that while you may have lower potential returns than from the point when you started, you may have very attractive returns from this point on.
“And my personal opinion is that in some senses, the market is not being rational about how it is pricing what these businesses will look like on the other side.”
One of the companies Kumar thinks the market is being irrational about is Lloyds Banking Group.
The banking sector was one of the hardest hit in the early days of the coronavirus crisis, with its falls exacerbated when the Bank of England ordered major players to halt dividend payments and share buybacks at the end of March.
Yet rather than running from the sector, Kumar took this as an opportunity to buy in.
“The UK banking sector’s capital ratio is 3x higher than it was in the financial crisis,” he said.
“If you add up the market cap of Barclays, Lloyds and RBS, just one bank in Australia is 50 per cent higher than all three of them.
“With Lloyds, you’re paying 0.5x book [value], so you’re already paying less than half what it would cost to recreate the capital in the business. But more than that, you’ve got a 25 per cent market share of UK customer accounts, which is a very dominant market position and one I’d argue is quite difficult to recreate. And you also have a £300bn mortgage book.”
He added: “What is really interesting if you look at the capital ratio of Lloyds is that it would indicate that it should be able to pay dividends again by next year.
“And if you look at what it might be able to pay in two years’ time, it really could be quite significant.
Kumar originally bought into the stock in the early days of the crisis, close to the period when the FTSE All Share bottomed out towards the end of March. However, he topped up his position after the stock fell close to 8 per cent last Thursday when it released its results for H1.
Performance of stock in 2020
Source: FE Analytics
The manager said that while the results looked bad – it saw a pre-tax loss of £602m compared with a £2.9bn profit for 2019 – these figures were already more than priced in.
“If you look at how negatively Lloyds reacted to what I thought was reasonably predictable, what I think is quite interesting is that the market is still heavily led by earnings momentum,” he explained.
“That is reflective of how your short-term earnings are doing and not necessarily what that might imply about the long term.
“This is a very honest opinion, and it’s been very wrong so far, but if you look at the banks, I don’t think it is like, say, shopping centres, where you could say that there is a structural trend that is making me nervous about the long-term judgement of their competitive industry positioning.”
This last point is perhaps the most important driver behind Kumar’s conviction in a long-term recovery in the sector. The manager said that while shares in retail banks look as if they are being priced for disruption, his analysis suggests that if anything, technology may be a tailwind in allowing these organisations to reduce their costs.
For example, he noted Lloyds has 17 million current accounts and 11 million digital ones and the cost of serving those customers will move lower as more of them embrace online banking.
And he said any attempt to disrupt them has so far been unsuccessful.
“For example, N26 is a German digital challenger bank that has raised over $680m and was allegedly the highest valued German start-up at $3.5bn,” he continued.
“In February it announced its departure from the UK current account market due to ‘Brexit uncertainties’, despite entering the market only after the referendum. Metro Bank raised over £1.4bn in equity and over £15bn in deposits, and yet its equity is now close to worthless as it was unable to lend successfully.
“The stickiness of retail deposits, cost efficiencies of scale and lending know-how make the franchises of Barclays and Lloyds hard to replicate. In time, both Barclays and Lloyds should be able to leverage their large digital footprints to reduce costs and improve returns.”
He added: “Banking is tricky, it’s undeniably difficult, because any business that has seen its revenue line fall 16 per cent because of interest rates is tough to support. And on top of that, you have higher impairments.
“But if you look at how these shares are priced, I think they will make attractive returns from today.”
Kumar is not the only one who is excited about the opportunity in the UK’s banks. In an article published on Trustnet towards the end of May, Jamie Ward of the TM CRUX UK Core fund said the sector offered “one of the best risk/reward trade-offs in the market”.
The Artemis Alpha Trust is down 17.4 per cent since Kumar joined as co-manager in May 2018, compared with losses of 13.6 per cent from the FTSE All Share and 18.02 per cent from its IT UK All Companies sector.
Performance of fund vs sector and index under manager tenure
Source: FE Analytics
The trust is trading at a discount of 16.36 per cent to net asset value [NAV] compared with 17.21 per cent and 17.44 per cent from its one- and three-year averages. It has ongoing charges of 0.94 per cent and is 8 per cent geared.