We believe financials remains one of the cheapest equity market sectors. They jumped sharply in price following the positive news around vaccines in November, as the sector is one of the biggest beneficiaries of economies opening up over the course of this year and into 2022. Their earnings are sensitive to economic activity, therefore the improving outlook has driven the rally as confidence in the earnings outlook for the sector over the next couple of years has risen sharply. This should not be a surprise.
At this point of the cycle the sector has discounted a much worse downturn than has actually happened, thanks to government and central bank actions to reduce the economic impact of lockdowns and changes in spending patterns. Looking back over previous recessions or market falls, having discounted the bad news financials have often outperformed almost immediately, whether it was the failure of LTCM in 1998, the TMT bubble in 2000, Iraq war in 2003, the global financial crisis, the Eurozone crisis or the UK referendum in 2016. We believe this time is no different and history suggests there is much further to go.
Earnings for the sector are forecast to be up 38.9% in 2021 and 10% in 2022, led by the recovery in the earnings of bank shares as new accounting rules have forced banks to make loan loss provisions much earlier in the cycle than previous downturns. As a result, these provisions were set when the outlook in the middle of 2020 was much cloudier and will prove to be too conservative. For example, under its base case forecast JP Morgan has stated it has excess provisions of $10bn.
In fact, the surprise of this downturn was that last year banks’ shares, as illustrated by the chart below, underperformed by more than they did in the global financial crisis, when banks were failing, and confidence in the financial system collapsed. Today it is very different. Bank balance sheets are strong and they have been part of the solution, providing a conduit for government-guaranteed lending to support businesses and allowing many individuals and businesses to take payment holidays.
S&P500 vs KBW Bank Index in 2008/2009
S&P500 vs KBW Bank Index in 2020
Source:Bloomberg, 31 December 2020.
Furthermore, regulators are likely to remove all remaining restrictions on banks paying dividends and buybacks at some point during the year. US and Asian regulators took a pragmatic approach, unlike their European and UK counterparts, in allowing banks to continue to pay dividends last year albeit capping the level of payouts. In December, the Federal Reserve announced that banks could restart buybacks, which will be accretive to earnings.
Outside the banking sector, insurance companies are also benefiting from the recovery on the back of an acceleration in the increase in insurance rates for commercial businesses as losses due to business interruption claims and the cancellation or delay of sporting events such as the Olympics which hit profits in 2020, on top of others, fall away. Asset managers and stock exchanges are also riding the recovery as fees generated from higher turnover from trading or the jump in assets under management from higher equity markets boosts profitability.
Against this background, share prices of some growth companies are hitting stratospheric multiples; as interest in stock markets and crypto currencies surges the risks of a repeat of 2000 come to mind. The madness is being repeated. Share prices are jumping on little or no news. Companies with little or no revenues have seen multiples put on their business that defy logic as evidenced by insider selling. Some investors are saying value no longer matters. However, we believe value always matters eventually.
If you had purchased a basket of global financials on the eve of the financial crisis in May 2007 you would have still made a return of more than 60% over the intervening period, despite the collapse in shares prices during the global financial crisis. By comparison, if you had bought a basket of global technology shares on the eve of the collapse in technology shares in March 2000 you would still be nursing a loss of over 45% assuming you held for the same amount of time, because your starting valuation was so high. In fact, you would have had to wait another three years, over 16 in all, just to get your money back.
The financials’ sector, despite the recent bounce, has seen a significant derating in its relative valuation to global equity markets over recent years. Absolute valuations remain below historical averages too. Investors who have rightly been focused on more growth areas of the stock market in recent years risk missing out on the rotation into those areas of the market hit hard by lockdowns which have much more upside.
There are also significant opportunities within the sector outside the main banking and insurance sub-sectors. For example, Asian emerging market financials are benefiting from Asia’s better handling of COVID-19 which will allow a faster recovery. They also continue to benefit from the low penetration of financial services to GDP relative to developed markets, underpinning their long-term growth potential. Payments companies continue to benefit from the shift from consumers using cash to card and the growth of e-commerce.
Global financials have risen by 55% over the past five years versus UK financials’ rise of only 17.5%. One way to get exposure is via the Polar Capital Financial Opportunities Fund which was launched in 2011 to provide investors with access to the largest equity investment sector globally. It has around 60% of its portfolio invested in bank shares predominantly in the US and Asia but also Europe and the UK, along with exposure to other subsectors such as insurance, property and casualty insurance, and data processing and outsourced services. It pays a dividend yield of close to 2%.
 Representative of the USD I (Inc) Share Class.
Nick joined Polar Capital in September 2010 following the acquisition of HIM Capital, and is manager of the Polar Capital Income Opportunities Fund and co-manager of the Polar Capital Global Financials Trust Plc.
Prior to joining HIM Capital, Nick worked at New Star Asset Management. While there he managed the New Star Financial Opportunities Fund, a high-income financials fund investing in the equity and fixed-income securities of European financials companies, which outperformed its benchmark index in all six years that Nick managed it. Previously, Nick worked at Exeter Asset Management and Capel-Cure Myers. At Exeter Asset Management, Nick managed the Exeter Capital Growth Fund from 1997 to 2003 which over this period was in the top decile of the IMA UK All Companies Sector.
John joined Polar Capital in September 2010 and is fund manager of the Polar Capital Financial Opportunities Fund and co-manager of the Polar Capital Global Financials Trust Plc.
Previously, John worked for HSBC as a banker based in Hong Kong and was the head of Asian research at Fox-Pitt, Kelton. In 2003 he joined Hiscox Investment Management which later became HIM Capital. John has won Lipper awards in the equity sector banks and other financials sector in 2010, 2011, 2012 and 2013.
George joined Polar Capital in September 2010 as an analyst on the Financials Team. He is a co-manager on the Polar Capital Financial Opportunities Fund, with John Yakas, and the Polar Capital Global Financials Trust, with John and Nick Brind.
He has over 10 years’ experience analysing Europe, Asia and emerging markets. Prior to joining Polar Capital, he was an analyst at HIM Capital from 2008 where he completed his IMC.