The rally in equity markets and consequently financials continued into February albeit the strength in sterling did act as a headwind to absolute returns. European financials led the rally, on optimism that a no-deal Brexit scenario will be avoided, Fitch’s decision not to downgrade Italy’s credit rating and hope that the ECB would extend support to the banking sector through an extension of the TLTRO funding scheme. Against this background, our benchmark index, the MSCI World Financials + Real Estate Index, rose by 1.5% and the Trust’s net asset value by 1.9%.

The biggest drag on performance was our holding in Swedbank, one of Sweden’s largest banks. Following the uncovering last year of Danske Bank’s (no exposure in the Trust) role in facilitating potentially $200bn of money laundering through its Estonian branch, Swedbank has been accused of handling approximately €6bn of suspicious transactions between 2007 and 2015 through its Baltic operations.

While the scale of Swedbank’s alleged involvement is materially smaller than Danske Bank’s, the stock fell 17% in the month, exacerbated by poor communications from Swedbank’s CEO, with investors having seen Danske Bank shares fall by half, wary of further revelations. What remains unclear is the extent that Swedbank has reported the transactions to the relevant authorities so materially mitigating any responsibility, but the share price is discounting a fine in the order of $5bn.

The announcement during the month of the merger between SunTrust and BB&T to create the sixth largest bank in the US led to outperformance by regional banks with expectations that similar mergers would follow. A more favourable environment for such mergers has come alongside a recognition by regional banks that the winners in a digital banking environment will be those that have scale and an ability to compete in terms of technology investment (BB&T’s 2018 technology budget was $1.1bn about a tenth of what JPMorgan or Bank of America spend).

As highlighted above, European financials outperformed in February. The outperformance comes despite a mixed Q4 banks’ results season (consensus 2019 EPS was -2% in the last month) with revenues affected by weaker trading activity as well as headwinds to net interest income from low interest rates and volume growth. This was partially offset by a continued benign asset quality environment (the corollary of low interest rates) with provisioning remaining at very low levels. Dividends broadly came in line with expectations leading to high total yields (including buy-backs) at Lloyds Banking Group (9.5%), Intesa Sanpaolo (10.1%), ING Groep (6.2%) and DNB (6.8%) which are all held in the Trust.

During the month we visited companies in Mumbai and Chennai which gave us the opportunity to discuss certain issues which have weighed on the sector recently. Overall, the meetings highlighted the current opportunity for private sector banks (the focus of our Indian exposure) given the liquidity and capital constraints on non-bank financial companies (NBFCs) and public sector banks respectively. The recent liquidity crunch has also improved private sector banks’ pricing power with loan repricing allowing them to offset higher funding costs.

In relation to Indian NBFCs, which were affected by a funding crisis at the end of 2018, it was clear that liquidity constraints have eased but the market is now more discerning in the pricing at which it will fund NBFCs. Asset quality improvements are expected to continue this year supported by improvements in the rural economy which has benefited from infrastructure spend (the amount, in kilometres, of roads built per annum has tripled under Modi) and Jan Dhan (financial inclusion programme, 340 million new bank accounts opened since 2014) and Aadhaar (biometric database) with stimulus to farmers now not siphoned off to intermediaries.

At the end of the month Berkshire Hathaway released its results and Warren Buffet’s annual letter to shareholders. While we do not own Berkshire Hathaway currently and he has come under criticism for some of his investments in technology, and more recently Kraft Heinz, it is instructive that in the second half of 2018 he increased Berkshire Hathaway’s exposure to US banks by $15bn, an area he arguably has done extremely well in, starting two new holdings in JPMorgan and PNC, both held in the Trust, with the only bank he reduced being Wells Fargo.

An abbreviated version of him talking on CNBC about his investment in US banks is also interesting:

“They’re very good investments at sensible prices, based on my thinking. And they’re cheaper than other businesses that are also good businesses by some margin. I was dumb not buying it [JPMorgan] earlier. But it’s a very well-managed bank. You can find a bank like JPMorgan, a business that earns 15% or 16% or 17% on net tangible equity, that’s incredible in a world of 3% bonds. Because if you have an instrument that could compound at 15% for 10 years and use the added capital, that’s worth way more than three times tangible equity at current interest rates, way more.” At the end of January, JPMorgan was trading on 1.9 times tangible book value.

We took the opportunity to add to our holding in Swedbank on the back of the fall in its share price as we think the fall is overdone. Despite the lack of visibility in the short term it remains a very good bank. We also added to our holding in AIA Group and to several of our UK holdings, including OneSavings Bank and Charter Court Financial Services. Against these we reduced a number of other holdings, including BNP Paribas and Wells Fargo, while we also sold our holding in Caixabank.

11 March 2019

Nick Brind

Fund Manager

John Yakas

Fund Manager