Entire tomes have been devoted to investing in the financial services sector - hardly surprising when you consider its size, and therefore its significance to the world's capital markets. To say the financial sector is large doesn't do it justice. Of the total market capitalisation of the S&P 500, the world's largest stock market index, financials account for just under 10% of the $28.5 trillion valuation.1 Turning our attention to the UK market, the sector's dominance is more pronounced still, representing over 25% of the entire market capitalisation of the FTSE All-Share Index.2
It is not merely its size, however, that has led the financial services sector to be referred to as the 'nervous system of capitalism', it's the fact that it permeates almost every aspect of corporate and personal daily life, forming a critical component of the world's economic engine. Make no mistake - a modern economy simply cannot exist without a well-developed financial system given its breadth and depth, the sector comprising a diverse range of industries including banks, investment managers, insurance companies, mortgage lenders and real estate firms amongst others, all of which provide the services required to help keep 'Main Street' functioning on a daily basis. It includes some of the largest organisations on the planet - from insurer Allianz, to asset manager Berkshire Hathaway to retail and commercial bank Citibank - together with many thousands of smaller players in every region of the globe.
A new-found resilience
Over recent years, the financial sector has not been without its detractors, and understandably so. The blatant self-interest which permeated its ranks at the turn of the century culminated in the financial crisis of 2007-2008, also known as the global financial crisis (GFC). Patently imprudent loan underwriting by banks led to the collapse of the US sub-prime mortgage market and caused the value of sub-prime lending to go into freefall, damaging financial institutions globally and precipitating the bankruptcy of Lehman Brothers on 15th September 2008, an international banking crisis and the most severe global recession since the Great Depression of the 1930s. Europe was not insulated from its effects, with bank bailouts widespread across the region, totalling £500 bn in the UK alone. All three of Iceland's major banks failed - relative to the size of its economy, it was the largest economic collapse suffered by any country in history.
In an echo of 2008's upheaval, the share prices of banks have been hard hit in the current COVID-19 downturn despite, on paper, being more resilient than they were 12 years ago through post-GFC structural reforms - considerably more capital and more liquidity in the banking sector, for example. In the UK, the three key measures of bank capital - overall capital ratio, Tier 1 capital ratio and Common Equity Tier 1 capital ratio - are up to three times higher than at the start of the global financial crisis, according to the Bank of England’s Financial Stability Reports. The Federal Reserve and the European Central Bank reached similarly positive conclusions regarding US and eurozone banks' resilience.
What drives financial earnings?
When reviewing the performance of the financial services sector, it’s instructive to contemplate the two principal drivers of earnings. The first is interest rates. Since a large element of the sector makes money by arbitraging short- and long-term rates, the precise relationship between the two is highly relevant: and the larger the spread between the two, the better. Debt, by virtue of its servicing costs being tax-deductible, typically offers a cheaper source of funding than equity, and hence will generally lower the overall cost of funding, thereby enhancing the return on equity. Whilst there are clear incentives to operate with some degree of financial leverage, banks are already highly leveraged institutions - the debt to equity ratio is commonly 95:5 - and profits are therefore strongly related to net interest margins, which has rendered lending a substantially harder business to be in over recent years ? and some believe may remain so, given the prospect of a 'low for longer' interest rate environment and the possibility that UK interest rates might turn negative. It's worth adding that insurers similarly find low interest rate environments detrimental given that premium income is largely invested in interest-bearing assets.
The second earnings driver is the velocity of financial transactions which, needless to say, is fuelled by consumer confidence and the health of the underlying economy. Whilst somewhat suppressed of late, economic expansion and the dilution of lockdown measures as the grip of COVID-19 loosens should catalyse a marked uptick in this measure.
Given these and other market challenges, it's unsurprising that financials as a sector has underperformed the broader market over the last decade: the MSCI World Financials Index has grown at an annualised rate of 4.42% whereas the MSCI World Index has grown at 8.84% - almost twice as fast.3 Despite these headwinds and continued market volatility however, The Bankers Investment Trust PLC - managed since 2003 by Alex Crooke, Co-Head of Equities, EMEA and Asia Pacific at Janus Henderson - is increasingly an enthusiastic investor in financials. Despite the sector's well-publicised past difficulties, the trust's allocation to financials remains at circa 25%, but is focussed on companies taking advantage of paperless payments rather than traditional banks and insurers. Visa, Mastercard, Moody’s, PayPal and American Express all feature within the top 20 holdings.4 Performance has been solid, the share price having outperformed the benchmark over one, five and 10 years - over 10 years, the trust's NAV is up 179.2% compared to the 119.2% of the benchmark.5 Meanwhile, dividend payouts have been equally impressive. Whilst the second quarter of this year was marked by widespread dividend suspensions and reductions - UK banks for example, and to a lesser extent insurers, were pressured by the Prudential Regulatory Authority to suspend dividend distributions amid the coronavirus crisis - the trust was able to maintain its 53-year unbroken run of dividend increases.
Why now?
A wide range of factors suggests that the outlook for financials over the coming year is genuinely positive, and it is worth noting that, this time around, rather than being the core of the problem, the banks are increasingly viewed as part of the solution. The contributory factors are:
-with the US presidential election now behind us, a degree of clarity has emerged; a similar level of clarification is anticipated as the UK's Brexit negotiations are finalised
-the imminent arrival of a number of highly effective COVID-19 vaccines suggests that a lifting of draconian lockdown measures and a return to normality may not now be far away
-rather than recapitalising banks, governments are providing guarantees to prevent both retail and commercial loans defaulting in the first place - this is almost the opposite of what happened during the GFC and should catalyse loan growth
-there is evidence of strong deposit inflows into banks globally - loan/deposit ratios have fallen markedly, such that they have ample liquidity6
-most businesses have already been accommodating historically low rates for many years and through focussing on reducing costs are now earning reasonable returns
-the sector was already attractively priced prior to the current sell-off, and current valuations have already priced in worse than GFC loan-book deterioration in both Europe and the US, to the point where large banks trade on only about 10 times earnings - considerably less regarding the likes of Citibank or RBS - and some banks and insurers can now be bought for less than half the value of their assets
-banking is particularly sensitive to the economic cycle given the highly leveraged nature of the business model, and so should respond well to any post-pandemic improvement in conditions
-recent years have seen an explosion of innovative ways to 'do' finance - the relentless rise of fintech, accelerating phenomena like micro-finance, 'open banking', mobile-only banking and the like are all serving to fuel sector growth and to motivate the next generation of customers, keeping incumbents on their toes. These new ways to deliver services to clients are being employed by the established financial firms to reduce costs and develop additional revenue from their customers
-a considerable opportunity remains in addressing the needs of the 'unbanked', i.e. those that don’t use traditional banking services - in the US, as many as nine million households are unbanked7; worldwide, circa 1.7 billion are unbanked, yet two-thirds of them own a mobile phone that could help them access financial services8
-finally, we may be wrong in the view of perpetually low interest rates: if inflation starts to rise as a result of central banks supporting economies, then long-term interest rates may rise; financials traditionally benefit both in terms of profitability and share prices if the spread between short and long-term rates expands.
Financial services companies are evolving their business models to meet post-pandemic challenges and increasing competition, and to continue to rebuild consumer confidence. They represent a significant proportion of global GDP and are fundamental to ensuring that the economy functions efficiently. Playing such an integral role in the lives of consumers, businesses and institutions, we continue to believe the sector should form a key element of any diversified portfolio.
Annual performance (cumulative income) (%)
Discrete year performance % change (updated quarterly) Share Price NAV
30/09/2019 to 30/09/2020 9.1 6.5
28/09/2018 to 30/09/2019 8.1 6.6
29/09/2017 to 28/09/2018 11.5 12.4
30/09/2016 to 29/09/2017 27.6 19.4
30/09/2015 to 30/09/2016 14.2 24.9
All performance, cumulative growth and annual growth data is sourced from Morningstar, as at 30th November 2020. Past performance is not a guide to future performance.
1Source: S&P Dow Jones Indices factsheet, 30.10.20
2Source: FTSE Russell factsheet, 30.10.20
3Source: Janus Henderson Investors, USD, to 30.10.20
4Source: Janus Henderson Investors, as at 31.10.20
5Source: Morningstar, total return, vs FTSE All-Share Index to 31.10.17 and FTSE World Index from 01.11.17, to 30.10.20
6Source: Standard & Poors Market Intelligence, Loan-to-deposit ratio at US banks hits 29-year low as transaction accounts surge, 25.06.2020
7Source: How America Banks: Household Use of Banking and Financial Services, 2019 FDIC Survey, October 2020
8Source: The World Bank, Global Findex, 19.04.18
Glossary
Capital ratio - A measure of the funds a bank has in reserve against the riskier assets it holds that could be vulnerable in the event of a crisis.
Tier 1 capital ratio - the ratio of a bank's core tier 1 capital?that is, its equity capital and disclosed reserves?to its total risk-weighted assets.
Tier 1 common capital ratio - a measurement of a bank's core equity capital, compared with its total risk-weighted assets, and signifies a bank's financial strength. Tier 1 common capital excludes any preferred shares or non-controlling interests, which makes it differ from the closely related tier 1 capital ratio
Volatility - The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment
Valuation metrics - Metrics used to gauge a company’s performance, financial health and expectations for future earnings eg, price to earnings (P/E) ratio and return on equity (ROE).
Market capitalisation - The total market value of a company’s issued shares. It is calculated by multiplying the number of shares in issue by the current price of the shares. The figure is used to determine a company’s size and is often abbreviated to ‘market cap’.
Liquidity - The ability to buy or sell a particular security or asset in the market. Assets that can be easily traded in the market (without causing a major price move) are referred to as ‘liquid’.
Leverage - The use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset, or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets.
Debt to equity ratio - The measure used to understand the degree to which a company is financing its operations through debt versus wholly owned funds. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.
