Is your portfolio positioned to benefit from the growth opportunities in global financials?
Despite the fact that global financials are set to benefit from the current macro cycle, have very favourable valuations, and should be one of the largest beneficiaries of the ongoing growth to value rotation, portfolio allocations to the sector generally remain light. In this article, Kokkie Kooyman explains why we believe that now is a good time to invest in global financials. An important highlight is the potential growth opportunity to be gained from the significant discount that banks are trading at relative to the market. He explains why there is room for this valuation spread to normalise this year, which should yield 20-45% upside for banks. He also provides an update on how the Denker Global Financial Fund is positioned to take advantage of these opportunities.
One must understand the macro outlook when you invest in global financials.
At Denker Capital, we do this by looking at various scenarios. Below we explain why we give the highest probability to the scenario that 2021 could be the start of a multi-year earnings growth expansion from global financials.
There are several indicators that lead us to believe now is a good time to invest in global financials.
• Consumer spending from the $1.9 trillion Biden aid package will most certainly push the US economy to run above capacity, igniting inflationary pressures. The planned $3 trillion infrastructure spending package will increase those pressures even further from 2022 onwards.
• This will most likely mark the end of a 10-year period of continuously low interest rates. The US 10-year yield has started signalling this shift.
• Where we are now in the cycle (just exiting a recession) is normally the best time to invest in banks due to increased demand for credit and lower bad debt charges. However, with a higher inflation outlook, the bank sector will get the additional benefit of wider interest margins through higher interest rates.
• Overwhelming evidence points to the fact that the second and third quarters of 2021 will bring very strong US consumption growth, which means year-on-year (YoY) earnings growth will be exceptionally strong.
• The US Federal Reserve (the Fed) has announced that those US banks that pass a capital test will be able to make their own decisions about how much they want to allocate to paying dividends and buying back shares. This is a material change because since 2008, they first had to get permission from the Fed before paying any dividends or committing to buybacks. This means that the excess capital that has built up during the Covid-19 period can be paid out to shareholders, which at the same time will reduce bank capital levels and therefore increase returns on capital.
• The above, combined with the steepening yield curve and the prospect of higher interest rates after a 10-year downward rate cycle, means that banks could be at the beginning of a multi-year earnings expansion cycle.
• The EU will benefit indirectly from stronger US growth (both via exports and US long bond yields).
• EU financials remain cheap relative to the MSCI World Index.
Figure 1: Consensus estimates of the MSCI Europe Financials Index price earnings relative to the MSCI World Index
Source: FactSet, 23 March 2021
• The heavy regulatory hand has helped suppress growth in the EU. However, similar to US banks, EU banks are now well-capitalised and ready to pay large dividends of 6% and more.
• Banks have adapted to the negative interest rate environment by ‘paying’ negative interest rates on deposits. This, along with their focus on efficiency in both their front office and back office, means that returns on capital have started increasing and bank management teams like that of ING in the Netherlands are targeting return on equity (ROE) rates of 10-12%.
• ING, for example, is trading at a discount to tangible net asset value (NAV) of approximately 30%, which means it is very attractively valued. The good banks in EU are not value traps.
Global financial valuations
Absolute valuations remain close to 2008 panic levels.
Figure 2: MSCI World Financials Index price to last reported book value over a 20-year period
Source: FactSet, 30 March 2021
Global financials relative to global valuations
While the global banking system is very healthy, the global financials index is trading at its widest discount relative to the MSCI World Index this century.
Figure 3: Consensus estimates of the MSCI World Financials Index price earnings relative to the MSCI World Index
Source: FactSet, 23 March 2021
How is the Denker Global Financial Fund positioned to benefit?
• We have 31% invested in the US.
– Roughly half of this is in US banks.
– We have started switching some of this exposure into the property and casualty insurance (P&C) sector since investors are ignoring the rate-hardening cycle and instead focusing on the interest rate cycle.
• We have 11% invested in Europe.
– Of this, only 5% is in core Europe (mostly in ING in the Netherlands).
– The other 6% is in Central Eastern Europe.
• We have a further 28% in Switzerland, the UK and Scandinavia.
• The rest is in strong emerging market countries like India, Indonesia, Russia, Korea, and Mexico.
– The UBS global research team recently forecast 2021 loan growth for these countries at 9%+ versus 2% for the EU and US.
We continue to look for mispriced opportunities within this global recovery.
Our experience and intimate knowledge of the sector allows us to continuously identify the best management teams and to invest when the shares are mispriced. Spectacular successes in 2020 included Tinkoff, Signature Bank, HDFC Bank and UBS. A country we have started investing in in January this year is Korea. Banks there are hated and are now amongst the cheapest banks in the world. This is despite the country’s export growth being strong (15% YoY as reported last week) and banks growing shareholder value consistently at an average of 9%+ per year. Trading at 0.4x price to NAV is exceptional value.
Many investors are at risk of missing out on significant growth opportunities that the further re-rating cycle offers.
Don’t be one of them.
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