Part I: Investment opportunities in the global financial sector

The effect of Covid-19 on global financials

Kokkie Kooyman
Portfolio manager and director

• We believe the market is presenting investors with what Charlie Munger calls ‘The Fat Pitch’ – a baseball term for a ball that is poorly pitched, allowing the batter to strike out confidently and strongly (hitting it out of the park) with very low risk of missing.
• The market fears: (1) a huge bad debt cycle and (2) the risk that banks will need to ask for capital at the bottom of the cycle. In this call we explain why we believe the market is wrong on both counts.

Developed market banking sector

Ben Kooyman
Equity analyst

• Capital levels now versus in 2008
  • In 2008 banks were involved in a lot of off balance sheet activity which destroyed capital.
  • Capital buffers, which have been built up over the years, are available to be accessed if necessary and can then be built up again later.
  • Liquidity is at highest levels since the 1980s.
• Bad debt provisions raised in Q1 2020
  • Bad debt provisions consist of charge-offs (actual bad debts), which are in line with Q1 2019, and reserve building (not actual bad debts).
  • Currently reserve building makes up the large losses for the year, based on companies’ macro assumptions, and these losses will remain volatile in the short term.
  • Generally, the banks are being prudent which could lead to reserve build reversals eventually if the market does normalise slightly.
  • No matter the provisions raised, the companies remain profitable and profitability should increase after Q2 when most reserves are built up.
• Income statements
  • In terms of net interest income, the US is under slightly more pressure due to the Fed cutting rates but also helped by the fact that loan growth has been at all-time highs.
  • Fee income very strong in investment banking activities and should remain relatively strong, while consumer banking fee income is under pressure but should bounce back quickly on normalisation.
  • There has been a slight reduction in expenses during the current crisis. Generally employees are still employed so there has been no real change in salary expenditure.

Developed market insurance sector and Latin America financial sector

Barry de Kock
Equity analyst

• The Denker Global Financial Fund has significant exposure to the insurance sector, with the bulk of the exposure predominately in US non-life businesses. We like these businesses for their defensive characteristics (we tend to favour underwriter-driven companies with modest investment leverage) and management teams who are invested alongside us.
• The insurance sector has been sold down along with the broader financial sector, and we are seeing opportunities to add to current holdings or take positions in companies we have followed for many years.
• We anticipate Covid-19 to have a meaningful impact on the sector, when considering both the assets and the liabilities of insurers.
  • We expect some pressure on revenues as GDP contracts, and pressure on net investment income due to lower interest rates.
  • Claims are likely to come from more affected lines of business such as travel insurance, trade credit and directors and officers liability insurance. Commentary around retroactively changing contracts to make insurers pay for business interruption claims caused by the pandemic is by far the biggest overhang on the sector at the moment. While certainly a material risk, we feel the probability is low that it materialises and we remain comfortable with our exposure to this line.
  • It is likely that the underwriting environment will improve significantly looking ahead as there are many lines of business that will need rates to rise to provide adequate profitability to the businesses writing them.
• In Latin America the fund’s exposure remains fairly modest and we are being more selective. We are invested in businesses with excellent track records of managing credit quality and strong capital ratios. Valuations in certain areas are very attractive and we are taking a measured approach to adding exposure to the region while being cognizant of a number of top-down challenges that exist.

Emerging market financial sector

Craig Metherell
Equity analyst

• We believe Asian emerging markets will remain the drivers of global growth in the coming years. Many of these markets have very favourable demographic characteristics in that they are large, young and growing rapidly.
• Smartphone, banking and mortgage penetration are all extremely low by global standards and we believe the financial sector is directly exposed to the exciting growth opportunities on offer in these countries.
• Many of these Asian emerging market countries are also in very strong fiscal positions with low debt to GDP ratios and the proportion of foreign currency denominated borrowings is low.
• Despite the favourable fundamentals, emerging market currencies and risk assets have been sold off aggressively and outflows have dwarfed those of previous crises.
• In our view, this has led to a dislocation in valuations between emerging markets and the rest of the world. The MSCI Asia EM Financials Index is trading at a 45% discount to its long term average P/NAV multiple whereas the MSCI US Financials Index is trading at only a 20% discount. Based on Shiller CAPE ratios, emerging markets have only ever been cheaper 3% of the time.
• Balance sheets and capital levels have strengthened since the global financial crisis and in sticking to our philosophy of identifying mispriced assets we are excited about a number of quality investment opportunities in the region.

Assessing opportunities in the sector

Kokkie Kooyman
Portfolio manager and director

• Based on our research and interactions with managements, we believe very few banks will generate losses in 2020 or 2021 and that they’ll continue to grow shareholder value.
• In terms of valuations, the financial sector is currently at a larger discount to the MSCI World Index than ever before – indicating it is at the epicentre of fear.
• The fears of seemingly unquantifiable risks have pushed share prices down to levels that create excellent investment opportunities.
• As certainty and buyers return to the market, they’ll find very few sellers – and prices should react strongly.
• After past crises financials bounced back strongly. See Figure 1 below which shows how the sector and the Denker Global Financial Fund bounced back after the global financial crisis.
• Today the valuations of the investments in the Denker Global Financial Fund are more attractive than they were at the end of the global financial crisis.

Figure 1: Calendar year returns of the Denker Global Financial Fund since 2004.

Source: Morningstar, 31 December 2019. Returns are annual returns and fund returns are net of the A class fees.
From 1999 to April 2004 the fund was managed under a different fund management company but by the same fund manager.

If you have any questions, please contact me at nigel@denkercapital.com

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