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Banking analyst expert Kokkie Kooyman outlines his confidence in the sector and the fundamentals underpinning his investment thesis. Despite the sector rallying over 30% in the last quarter of 2020, Kokkie believes there is far more upside to the share prices in the unloved banking sector. Basel III is a global regulatory framework on bank capital adequacy, stress testing and liquidity risk that was introduced in response to the deficiencies in financial regulation after the global financial crisis in 2008. This has ensured that banks remain well capitalised despite the excessive expected credit loss provisions, as required by IFRS 9, that banks have reported in its financial statements. The possibility of a sector re-rating, normalisation of dividends and resumption of share buybacks makes this unloved sector appealing. – Justin Rowe-Roberts
2020: Looking back
By Kokkie Kooyman
In our four 2020 webinars we initially (April 2020) said banks were in a much better position than 2008 and hence the price falls of February/March were totally overdone and this presented a great investment opportunity (potential doubling in 12-18 months).
In June we again flagged the investment opportunity: We said that whilst in 2008 banks were the problem, our discussions with managements were highlighting that in 2020 banks were being used as part of the solution by governments.
We maintained that despite excessive provisions they made in Q1 and Q2 (note: provisions not bad debts) they would come through the crisis well, remaining profitable and growing shareholder value. The 30 year low valuations more than made up for any unforeseen downside risks.
In the third quarter we started alerting investors to prepare for the end of the Covid lockdown induced recession. The probability was increasing rapidly that 2021 would see a strong economic rebound (wave 2 has since pushed this out a bit).
We agreed with the RMBMS view that as growth returned, (US, but also global) unemployment would start falling, leading to the normal upward cycle of post-recession recoveries.
Banks (and insurers) would benefit from returning demand for credit, and a non-repeat and possible reversal of provisions. This and the Covid induced fast tracking of digitalisation strategies would see them report strong jumps in profitability in 2021.
In our last two webinars we started looking forward to a vaccine, normalisation of dividend payments (important for EU banks) and resumption of share buyback programs with inflationary pressures and a steepening of the yield curve being further out positives.
Well, most of this is close to happening but now we’re having this rally, the question is raised whether to take profit?
The strong performance in Q4 (+31%) must tempt investors in the financial sector about taking profit.
We would strongly urge you not to do that. Why?
– The S&P 500 Banks index is still -9% since 1 January 2020 and the MSCI World Financial index only +1.4% (up to Friday, 7 January 2021 at 17h00)
– The environment we could be moving into ticks all the boxes for banks:
o Increasing demand for loan growth
o Reduced competition
o Strong balance sheets and excessive reserves
o Possibility of net interest margin improvement
o And ito the Property & Casualty (P&C) insurers we should witness increased demand at higher rates
– Most important: Earnings and shareholder value growth will surprise markets, one of the most important drivers of share price performance.
– This is normally the time of the cycle when the financial sector re-rates. Besides, despite the strong rally the sector remains misunderstood, under-owned and undervalued.
but much more important than this: The big decision investors have to make now is regarding the risk of inflationary pressures from the combined interaction of excessive monetary stimulus and resulting growth. The 10 year yield has started re-acting, but still has quite a way to go. Authers’ article points out the correlation between a steepening yield curve and positive returns from the financial sector.
We have not yet built in the possibility of higher interest rates into our forecasts. But we know that markets look forward and will react before it starts happening. Investors will have to decide now whether the yield curve will steepen or not.
A Biden presidency brings potential positives and negatives but for our Global Financial fund the positives outweigh the negatives:
– Inflationary policies (more stimulus, continued low interest rates) and more normalised global relationships, especially ito trade barriers
o Good for emerging markets (EM) ito their currencies and growth (weak US$)
o A yield curve steepening that will gradually help bank margins and insurance investment returns
o Increased certainty which means growing investor demand for medium and smaller growth companies
o Continuation of the growth into value rotation
– The negatives are increased regulation and further out a high possibility of higher tax rates
So, What Now?
Sure, a lot of the easy, low risk “doubling” we spoke of in Dark March is gone.
Yet, the valuations and improving growth rate leaves considerable upside:
– The sector is still trading below its 10 year average valuation (and these 10 years were the years that saw post 2008 recapitalisation, increased regulation, relentless pressure on net interest margins from lower interest rates)
– Most managements have adapted to lower interest rates and the Covid lockdown has enabled a big push to increased cost efficiencies
– The recovery part of the cycles of the past 50 years (and I’ve witnessed 40 of them), have been consistent in:
o Falling bad debts (from a high level)
o Recoveries and reserve releases
o A gradual re-rating of the sector from recession lows as growth recovers
European and UK financials valuations remain considerably lower than they were after previous recessions
Post the 2002 recession the Global Financials fund generated returns of +70%, +30%, +38%,+21%, +24% (2003,2004,2005,2006,2007).
I can bore you with our top 20 but will just use one example: LIC Housing Finance Limited.
LIC is a housing finance company in India, and due to the Indian government having a controlling interest most of the mortgage loans are to civil servants( ie –very low default risk)
The “short-termism” of markets can be seen in that despite this low risk and its 20 year track record, the share was pushed down to a Price-to-Net Asset Value (P/NAV) of 0.6x…
Over the past 10 years it traded at an average P/NAV of 1.8x.
At the moment it is still only on 1.0x despite the fact that it will (our forecast) report an ROE of 14% for the financial year ended Mar 2021. (refer to the table at the end of this mail: every time LIC reached 0.6x P/NAV it’s price subsequently doubled)
We’ve used the price weakness of the past few months to add to the funds’ holdings and at 6% it is now the largest investment of the fund.
In 2-3 years’ time it should trade at 1.8x again – that represents upside of more than 100% (re-rating to 1.8 plus NAV/share growth)
This is just one example of many shares in the fund. All of them have similar characteristics: Good track record of growing shareholder value and a post Covid tailwind behind them. (TCS, Essent, Alleghany, Shinhan HDFC Bank, Keycorp, Prudential, Legal and General, One Savings Bank, Arch Capital, Erste Bank, ING, etc). All still trading below their 10 year valuations and will report excellent earnings growth for the next 2-3 years.
I am a barber (to misuse Warren Buffet’s quote). But I do have 30 years + experience specialising in this sector
This is not the time to disinvest from financials, in fact, the opposite.
To help you make start thinking about the potential inflection point Authers refers to, I’ve added a few graphs from RMBMS* which highlight the increasing possibility that we might indeed be on our way to stronger (than anticipated) world growth and inflationary pressures (partly due to central banks initial unwillingness to hike short term rates too early).
*RMBMS “Charts of the Week” from Ian Doyle
Bear in mind, this is unedited and without all the necessary checks and right sizing and beautifications – that will happen next week
Commodities breaking out of a 13 year downtrend?
US bond yields are only just above their 12MA; +2SD would equate to >1.6% on the 10yr. The historic European relative outperformance if this happens is notable.
The above are all from Ian Doyle’s weekly and daily – which I must say is one of the best and most comprehensive I’ve seen ito a summary of daily events.
I must add RMBMS have from April 2020 started warning that Recoveries follow Recessions and that this recovery will be be stronger and quicker than markets expect and that this will have consequences ito asset allocation and stock picking.
A Day of Drama
By John Authers
(Bloomberg Opinion) – I sit down to write this at the end of a day of historic political drama in the U.S. Friends in New York feel as shocked by today’s events as they were by 9/11 – and having also lived through that, I tend to agree. In Congress, politicians drew parallels not only to 9/11 but to Pearl Harbor, and to the burning of the Capitol by the British army during the War of 1812. The bloodshed and death toll this time weren’t remotely comparable to any of these events, but beyond that, those comparisons seem perfectly reasonable.
Meanwhile, it was also a dramatic day on the markets. These two things have almost nothing to do with each other.
I am not alone in finding it hard to muster enthusiasm for offering up market analysis. It seems inappropriate somehow. The staff of High Frequency Economics, a consultancy producing daily commentary that I often cite in this newsletter, opted not to publish any market analysis for their subscribers tonight. This was the first time they had done so since 9/11, and they explained why with a beautiful piece of prose that I will quote at length:
This is not a time to remain quiet and hope for the best. It is incumbent upon every person who believes in democracy and the rule of law to make their voices heard in a call for peace and unity, regardless of political party or affiliation. The only way forward is together. We at High Frequency Economics are disgusted by the role of the President of the United States in inciting this riot, and we are saddened that he cannot find the character to stand up in front of the mob he has created, quell the violence and send everyone home. Responsibility for this outrage rests securely on his shoulders. He has lied, using the sanctity of his office to convince those with less power, income and resources than he to do his bidding.
The handful of people breaking the law and resorting to violence represent only the slimmest fraction of Trump voters. The majority of Republicans, Democrats and independents condemn the actions of these rogue insurrectionists. Even so, to our readers around the world, we are embarrassed. We know that the United States can do better than the images that are displayed in the news.
This is a time for reflection, not market data or economic trends. However, to bring this back to our own remit — the economy and the markets — we expect this episode can and will affect investor sentiment about owning US securities. That said, we believe the United States’ institutions are strong enough to survive this insurrection, and that President-elect Biden will peacefully take office on January 20. However, we still have to get through the next 14 days before that happens. How smooth the process will be remains to be seen. Perhaps today’s events will motivate members of both parties — centrist, leftist and right-wing — to come together. That will play a large part in how policy will be implemented over the next four years.
I applaud them for their first two paragraphs, with which I agree wholeheartedly. Today’s scenes were painful. Are they right about the impact this could have on markets and sentiment?
Despite the immense impact on people across the country, my best guess is that markets will shrug this off as easily as they shrugged off the demonstrations (many of which turned violent) that followed the police killing of George Floyd during the summer. Capital markets have a long history of being unbothered by political street violence. This was true even of the horrors of 1968 (a good year for the stock market). Generally, markets have confidence in underlying institutions and believe that riots will have little or no practical economic effect. Even this time, it looks as though U.S. institutions will hold — albeit after an almighty scare — and markets are allocating money accordingly.
Another reason, as the team at High Frequency Economics points out, is that the Trump presidency has only two weeks to run. Judging by the fevered speculation of the last few hours, there is a real chance that there will be an attempt to invoke the 25th Amendment, and remove Trump from office on the grounds that he is no longer fit to occupy it. This would be an extraordinary event, and the greatest constitutional crisis at least since Watergate. But the prospect of a fortnight of Mike Pence as caretaker president doesn’t appear to scare the markets. After that, there is now certainty that the nation will have two years of unified moderate Democratic government. That will have its pluses and minuses, but it isn’t too scary.
Such calculations might explain the ice-blooded judgments made in trading Wednesday. The day started with the news that Georgia had handed the Senate to the Democrats. Ostensibly a problem for markets, it was greeted by a fall in volatility, and a rally for the S&P 500. This was textbook: Uncertainty had been resolved.
The invasion of the Capitol took place with almost two hours of trading left. As the chart shows, it prompted a sharp rise in the VIX volatility index, and a tumble for the S&P 500. But by the close, volatility was back to the level at which it had started the day, and the stock market had held on to some of its gains:
By far the greatest impact of the Georgia election results was felt in the bond market. A Democratic Senate is perceived as putting upward pressure on yields. And indeed, yields rose throughout election night, breached the 1% level and kept rising. A shocker like an armed invasion of the Capitol might have been expected to send investors rushing for the haven of bonds, and it did — but as the chart shows, this was only enough to bring the 10-year yield down by a bit more than one basis point. The shock value of the insurrection was tiny compared with the prospect of more expansive fiscal policy:
As the evening has continued, with a number of Republican senators backing down from their intent to vote not to certify the election results, the chances of a major constitutional set-to seem to have receded. A two-week Pence presidency would eliminate much uncertainty. And so the calculation seems to be in that the insurrection can be safely ignored.
These are all risks that can be measured, at least to some extent, and if these are the judgments being made by investors they are probably correct. But there is a dangerous tendency to dismiss risks that can’t be quantified. These events could have a dreadful if unquantifiable effect on U.S. “soft power.” The big outstanding risk is that a significant current, numbering in the millions, continues to believe that Trump was denied by a fraudulent conspiracy, and is prepared to resort to further displays of resistance. I have no idea how to quantify that risk, but it exists. Should it come to pass, it would have a serious impact on the U.S. and the world — and, in passing, on the markets.
Taking it to the bank
Somewhat anti-climactically, let us now turn to the drama in the markets. Most dramatic was the recovery for banks. They have been deeply out of favor for a long time. But the stocks of big U.S. financial companies have been on a tear since Pfizer Inc.’s “Vaccine Day” in early November. With a day of massive outperformance Wednesday, they have now outperformed the rest of the S&P 500 by more than 30% in three months, and have made back all their lost ground, in relative terms, since last March. They still have to regain their losses from the first few weeks of the Covid-19 shock, but it is still quite a revival:
This wasn’t just an American phenomenon. Banks in the rest of the world haven’t lagged their local markets quite so badly, because they don’t have FANG stocks to compete against. But they’ve trailed badly, and enjoyed a big recovery Wednesday:
Why would President Biden with Democrats in the ascendancy in both houses of Congress be such great news for banks? Because of the yield curve. Banks classically make a lot of their money from the gap in interest rates at which they borrow and lend. The steeper the yield curve, then, the greater the opportunity to make money. And curves have sharply steepened in response to hopes that the government will now start splashing money around, borrowing more and pushing up longer rates. This is true of the gap between both three-month bills and two-year bonds and the benchmark 10-year bond:
But this argument can only be taken so far. As Chris Davis, the veteran expert in financials who runs the Davis Financial Fund, points out, it would be just as easy to turn the Georgia results into an excuse to sell. President Biden with a unified Congress is likely to be much more unkind to Wall Street, and to beef up consumer protection once more in a move that will be unwelcome for retail banks. In any case, a steeper yield curve is less important to their profitability than it used to be.
That might in turn imply that the Democrats’ capture of the Senate was more of a convenient excuse to start buying banks than a reason to do so. The last such excuse came with the 2016 presidential election, when bank valuations (as measured, as is standard for the sector, by price-book multiples), last enjoyed a surge. Hopes of expansive fiscal policy then were dashed, but this time hope is rising once more. U.S. banks are once more trading above their book value:
Is there a valid bullish case to be made for them? Davis made a good attempt. They have done undue penance for the disasters of 2008, and this has gone unrecognised. In 2010, they accounted for 15% of the S&P’s earnings, he says; by 2019 that reached 24%. Despite this, their share of the total market cap of the S&P slid from 18% to 12% over the period. Some but not all of this can be accounted for by the rise of the FANGs. This is how the S&P 500 Financials index has performed compared to the rest of the index in this century:
There is plenty of room for them to recover. Last year, Davis points out, the banks further had to deal with onerous (but probably correct) requirements from regulators that they beef up reserves to guard against the widely anticipated risk of a wave of bankruptcies. This major credit event didn’t happen, but the extra reserves still ate into banks’ profitability. They also showed themselves able to deal with the sudden drying up of liquidity early in the year. And, Davis says, they still managed to be profitable even with a flat and briefly inverted yield curve.
On Davis’s argument, trust in banks was so low (for good reasons after the disastrously irresponsible lending that sparked the crisis) that they needed to show they could weather a crisis and a recession before trust could be regained — much as Big Tech underwent a decade of penance after the bubble burst in 2000, before rallying again after the Great Recession. It’s just possible that banks have finally done enough to win back trust, in which case there is a long way for them to go.
They aren’t as dramatic or as important as the horrifying events on Capitol Hill, but it’s worth taking a look at the banks.
Cyril Ramaphosa: The Audio Biography
Listen to the story of Cyril Ramaphosa's rise to presidential power, narrated by our very own Alec Hogg.