Investing in global financials in times of fear
Despite company results beating expectations, valuations of global financial stocks are down. They are at post-Global Financial Crisis and post-Covid-19 levels again, mainly due to the fear of sharply higher interest rates and a recession. These valuations indicate that the market is expecting the worst, but our research leads us to believe that the worst is not going to happen and that investors are being offered another chance to invest.
History shows that when investors took advantage of attractive valuations during times of crisis in the past, they were rewarded with excellent returns.
Over the years, our global financials team has built up tremendous expertise and understanding of the sector. We spend a lot of time researching companies and understanding the drivers of their performance – which is especially important at times like this. We share some of our findings below.
Despite the significant short-term pain that was felt in previous crises, the subsequent returns were enormous.
Except for the period following the 2011 European sovereign debt crisis, the Denker Global Financial Fund has outperformed after most of the large drawdowns since 2008. The recovery after the European sovereign debt crisis was more subdued due to the European Central Bank introducing its quantitative easing policy, which eventually led to negative interest rates, putting big pressure on bank profitability.
Figure 1 illustrates how the financial sector tends to be sold off most in the run-up to a crisis, but how markets and the sector both recover after the large drawdowns. Investing in financials after a market correction has produced exceptional results in the past, which the post-2008 recovery highlights. To put these figures into the current context, as at 30 June 2022 (in US dollar terms): Since the MSCI World Index’s peak on 4 February 2022, the Denker Global Financial Fund A class is down 24.1%, the MSCI World Financials Index (the fund’s benchmark) is down 19.7% and the MSCI World Index is down 15.9%.
Figure 1: Historically, the fund has outperformed after most large market drawdowns.
Source: FactSet, Denker Capital, 30 June 2022. Returns for cumulative. Returns are net of the A class fees of 1.25%. For a summary of the fund’s annualised returns since inception, please scroll to the bottom of this article.
The two scenarios the market fears most today are a stagflationary period and a recession.
Our research of the stagflationary environment over the 1970s and 1980s highlights that bank earnings were positively correlated to rising inflation and interest rates. During this time, banks performed well due to higher interest rates (which widened their net interest margins) and good loan growth (driven by inflationary pressures), whilst interest rates weren’t hiked enough at the time to cause high bad debts.
However, the market’s concern now seems to be that the Fed will hike interest rates too much – which eventually will lead to a recession. Again, Figure 1 highlights how banks came through both the 2008 and 2020 recessions well and bounced back strongly afterwards. Note, however, that in each case the major driver of outperformance was the level of starting valuations, with the degree of outperformance in each period being determined by the level of the starting valuations.
The key to being rewarded over the long-term is ensuring you are invested in the right opportunities.
In the Denker Global Financial Fund we’re focused on being invested in good quality financial companies. The fund is well diversified in terms of geography (the US, Europe and emerging markets) and within the sector (investment banks, general banks, debt collectors, exchanges, property and casualty insurers) and also between large-, mid- and small cap companies.
Compared to previous times of market lows, the current valuations are back to where they were at the end of 2008 and March 2020 (and for a large number of banks and insurers, below those levels). This gives us very high conviction in the Denker Global Financial Fund’s ability to outperform in the future on a relative basis.
In the section below, each analyst on the global financials team provides some insight into the opportunities in the areas they cover.
Developed market financials
After a long period of record low interest rates, the developed economies have started to hike interest rates to combat ever increasing inflation risks. The effect of rising interest rates is slightly different across developed markets, but the positive and negative results should be broadly similar.
With developed market banks, we should see the first few interest rate hikes of the current cycle flow almost directly into the banks’ income statements via higher margins – resulting in the benefit of higher net interest income.
You could almost call this ‘free income’ for banks, because the income benefit comes with no increase in operating expenditure. We expect income to be driven up by 10-15% across the banks.
We believe that the market has not yet taken this benefit into account, so we’ve gradually been increasing our allocation to include more interest rate sensitive banks which show extremely good value. Each bank’s balance sheet is structurally different, and so each bank is differently positioned. When allocating to banks, our research is focused on understanding the different drivers of performance and the possible effects that this will have on each individual bank.
The income statement benefit (combined with very low price-to-earnings multiples, record high dividend yields, strong buyback programs to further increase shareholder value growth as they return excess capital) makes many of the banks in our universe extremely attractive investments at this stage.
We’re also considering the potential negative effects of rising interest rates on banks.
Market sell offs, due to the prospect of rising interest rates, can have a negative effect on wealth managers, asset managers and certain business lines of investment banks. So, to avoid some of the potential negative income effects, we’ve generally shifted our allocation to the banks that aren’t as exposed to these areas.
Higher interest rates are likely to increase the level of bad debts which the banks must account for. We are currently not overly concerned about this as:
- Banks are very well capitalised and still have Covid-19 induced bad debt reserves on their books.
- Banks have generally stayed away from the higher risk lending areas in recent years, going for the slow and steady lending approach instead.
- At this point it appears that, in terms of lending, consumers are in relatively good shape and none of the banks we research have shown signs of stress.
- Thanks to post-Global Financial Crisis regulations, the loan portfolios of banks are very well diversified and lower risk when compared to 10 to 20 years ago.
- Banks have focused on their cost levels and their cost-to-income ratios are lower than they have been in a long while.
- As discussed above, the higher interest rates will add considerable income to bank income statements, more than making up for any possible losses from higher bad debts.
The risk of a recession is always a possibility, so testing the impact of this on our portfolio is part of our process.
Therefore, the portfolio is also invested in non-banking companies that could benefit from a recession over the long term. Examples include debt collectors who have the opportunity to buy books at extremely attractive multiples and then collect them over 10 years as economies normalise.
Some of the more fee-income based businesses’ (like the exchanges) share prices have also started to come down as valuation multiples have decreased.
We are continuously assessing these opportunities to identify attractive entry points into some of the quality compounders of the future.
An example of a developed market bank which has drastically changed its balance sheet is Signature Bank.
Signature Bank has produced extremely strong results and has been growing its loan book at over 20% over the last few years. The bank had an excellent 2021, with the share price appreciating 139% for the year. It has been one of the first movers in the blockchain and Bitcoin space, which has not helped sentiment in the short term. In Q1 it delivered an impressive return on tangible equity of 16.1%, but the share price is down 35% year-to-date (for long-term investors this presents an opportunity).
Figure 2 below paints a strong picture of how a well-managed bank, like Signature Bank, can benefit from higher interest rates if it’s correctly positioned. The numbers are estimates, but they highlight quite well the differences that changes to a balance sheet can make to an income statement if interest rates increase. For example: At year end 2018, Signature Bank’s net interest income would have been down 17% from a 400bps increase in interest rates. As the balance sheet stands now, they estimate a benefit of 49.6% in the same scenario – that’s a 66.6% swing from the 2018 effect. We believe that the market is wrong about this company, and that current valuations are providing us with an opportunity.
Figure 2: An illustration of the effect of interest rate increases on Signature Bank’s net interest income
Source: Signature Bank, Q1 2022
Emerging market financials
The Denker Global Financial Fund typically has around 25-30% exposure to emerging markets. In our view, this is a key differentiator as we are attracted by the exciting long-term growth potential offered by these markets. In volatile times we find that emerging markets, and particularly their currencies, can underperform. But through the cycle (over the long term) we believe the attractive fundamentals make for a compelling investment case. Our bottom up research process ensures we focus on the quality of a business, its ability to generate a consistently high return on capital and investing in it with a margin of safety when it comes to valuations.
Not all cycles are the same and, therefore, it is not always the case that all emerging markets move in unison.
The beginning of 2022 was characterised by the Russian invasion of Ukraine, which was extremely negative for Russian-linked assets.
While we regret not acting with more conviction when realising the potential fallout the invasion could have, we did reduce our exposure to Russia. Our direct Russian exposure now consists only of an investment in the London listed global depositary receipts of Tinkoff Credit Services. We do still have indirect exposure through investments in companies that are close in terms of geography.
One such example, is our exposure to the two Georgian Banks (TBC Bank and Bank of Georgia). Georgia and Russia and have not enjoyed the friendliest of histories but their relationships have improved over time. So, while the geopolitical risk caused the stocks to de-rate, our discussions with their management teams gave us comfort that the risk was lower than the market feared. Recently, Bank of Georgia reported an excellent set of Q1 2022 results with shareholder value growth of more than 25%, providing further support to our view that the core operations were uninterrupted by the war.
A result of the Covid-19 induced supply chain bottlenecks and the war in Ukraine is that commodity prices have continued to rise.
The rising oil price has received the most attention recently, but commodities such as coal and palm oil have also experienced steep price increases (see Figure 3 below). As a result, we have become increasingly excited about the opportunity Indonesia presents.
Indonesia is a large and fast-growing country. Additionally, according to Alliance Bernstein research, coal and palm oil exports are estimated to make up around 4% of GDP. The sharp rise in prices of these two goods has resulted in Indonesian terms of trade improving dramatically, which has supported the currency and bodes well for economic growth. Given these developments, forecasters have revised economic expectations for Indonesia. Most notably, a previously expected current account deficit has now turned into a burgeoning surplus. JP Morgan expects a 2022 current account surplus of 5% (previously -0.4%) for Indonesia. As the financial sector is a major facilitator of economic growth, by providing the necessary financial capital, the banks are well positioned to enjoy the positive trickledown effect. After two years of navigating the challenges of Covid-19 we believe the outlook for the Indonesian banking sector has fundamentally improved. Excess capital, liquidity and provisions mean balance sheets are very strong and geared towards increased lending opportunities, better transactional activity, and the prospect of higher interest rates. Combined with what we considered attractive valuations we have increased our exposure to Indonesian banks.
Figure 3: Thermal coal, crude palm oil and crude oil prices have all increased.
Source: JP Morgan, Q1 2022
Fintech has caused a major, but positive disruption to the traditional financial sector. The availability of cheaper and more efficient ways of providing financial services to customers has forced incumbents to be on the front foot. It’s also allowed new entrants into a market that has traditionally benefitted from barriers to entry, such as regulation and scale. We have actively followed this space for years, given our direct exposure to fintech businesses and the need for us to challenge the incumbents to adopt newer technology in their business models.
Many large global financial players have been at the forefront of technological innovation and this has given us indirect exposure to fintech businesses. However, we have also invested in businesses where fintech is the very essence of their business model. This includes businesses like Tinkoff Credit Services, Visa, Signature Bank, Upstart and VEF (a holding company with investments in emerging market fintech businesses). However, it is important to note that our exposure to what we consider unproven or new age fintech companies has been limited to this point. This has meant that, so far, we have avoided investing in companies we’ve believed to be very richly valued and that in many cases experienced exponential revenue growth but had little to show in terms of cash flows or profits.
As already mentioned in this piece, the negative effect that higher interest rates have had on valuations has been swift. Given the extrapolation of recent growth trends and high valuations, the fintech sector has not been spared. The Indxx Global Fintech Thematic Index which includes companies such as Adyen, Coinbase, Affirm, Block and Stone is down 56% from its October 2021 high. The share prices of Coinbase and Affirm are down 81% and 82% this year alone. Businesses with longer track records, such as PayPal, have not been immune either with a decline in share price of 63% year-to-date after having to reassess their growth targets. The returns above are as at 30 June 2022.
What we consider a much due reset in valuations in the fintech sector has made us excited about new investment opportunities. In many cases we believe the business models are robust and present a new way of doing things. A fall in share price does not necessarily imply a broken business model but it does mean more reasonable expectations are priced in. In many cases market corrections, like we’re currently experiencing, provide ideal opportunities to invest in quality businesses at attractive valuations. For this reason, we are paying close attention to the fintech sector and some of the new age fintech businesses.
Figure 4: YTD price moves in selected fintech companies (USD)
Source: FactSet, 30 June 2022
The Q1 2022 results produced by our insurance holdings were strong once again, with our companies delivering robust premium growth and continued improvement in underlying loss ratios – both of which we expected, as our companies continue to take advantage of and benefit from the tough market conditions in the industry.
Management teams across our insurance portfolio continue to be optimistic on the underwriting outlook for their businesses, and a number have also highlighted the additional tailwind of higher interest rates resulting in higher net investment income. Given our holdings have conservative, short-duration investment portfolios we expect this benefit to materialise quickly, and indeed most companies have confirmed with us that reinvestment yields on their portfolio today are materially higher than the current yield on the portfolio. We anticipate the recent moves in yields should add an additional 1-3% to returns on equity across our holdings.
The businesses are well capitalised to remain nimble, take advantage of further industry opportunities and deliver attractive shareholder returns over time. In our opinion, valuations do not reflect this outlook and the non-life insurance sector remains a safe-harbour during volatile markets. This justifies our sizeable position in the sector.
Investors often ask us what we expect in the times ahead.
It’s important to bear in mind that markets tend to start falling 12 months before a recession and then bottom soon after the recession starts.
This intuitively makes sense. Once the market gets a feel for how bad the recession is going to be, it starts looking forward. In 2022/2023 we may get that feel for how bad the recession could be when inflation peaks and starts falling, as that will indicate that we’re close to the peak in interest rates.
We now need patience to see how the environment plays out.
At the moment bank valuations reflect that the market is expecting a bad recession (a so-called ‘hard landing’), but the Fed’s annual bank stress test (June 2022) highlights that banks are more than adequately reserved to continue lending even in a tight recession. So, we should see a strong bounce when the environment becomes more predictable.
For example: Wells Fargo has fallen to a forward Dec 2022 P/tNAV (price to tangible net asset value) of 1.0x; Citigroup to 0.6x; JP Morgan to 1.1x; and Socgen 0.3x. So, valuations (both in absolute and relative terms) highlight the extent to which the financial sector has de-rated.
Experience has taught us that markets overreact in downturns.
For investors, the most important trait is the emotional strength that enables them to not get affected by the fears and negative sentiment around them.
The companies in which the Denker Global Financial Fund invests have been chosen for their quality and proven ability to grow shareholder value in both good and bad times.
History shows us that when you invest in well run companies with good track records and you invest in them when they’re trading below intrinsic value (and even better, below historically average valuations), then you do well over time. The portfolio is currently trading at an average price to book ratio of 0.9, showing that there is plenty of opportunity to earn attractive long-term returns from carefully selected global financials.
Figure 5: Annualised returns (USD) since inception as at 30 June 2022
Source: Morningstar. Returns for periods shorter than one year are cumulative. Returns are net of the A class fees of 1.25%. Inception date: 5 October 2004. The highest annual return in the last 10 years was 29.7% and the lowest was -17.2%.
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