It’s time to buy back into the banks

It's tricky terrain, but financials are a smart contrarian bet for the brave, says David C Stevenson.

I've just returned from a half-term holiday trip to the US. While I promise not to bore you with tales of wonderful weather and a robust economic recovery, one isolated observation has stuck with me in the days after returning to a wet and windy UK.

Sitting on a sleek, fast train in the San Francisco Bay area I was struck by an advertisement on a local BART train (the Bay area version of Transport for London) suggesting that an SPDR exchange-traded fund (ETF) investing in US financials and banks might be a smart investment move.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

There in the list of holdings in the ultra-low-cost fund were all the names that we've grown to hate, including that of banking giant JP Morgan (the same day I saw the advertisement, it had agreed to pay nearly $13bn in fines), fellow investment bank Goldman Sachs, and a bevy of smaller names.

Yet, here were San Franciscans being encouraged to invest in banks as a long-term investment idea. Shurely shome mishtake?

On my return to Britain, a very different set of observations hit within a matter of hours. The Co-op Bank has slumped into near bankruptcy, while poor old RBS is still trying to limp along with a vast bad bank' yoked to its more progressive, profitable domestic high-street operation.

Financials basket case or smart bet?

Are financials and more specifically the banks still a basket case? Or are they the smart contrarian bet? The hard numbers tell an important story. Last week, a note from huge fund-management and indexing business Russell reminded us that "global banking stocks have continued to show strong performance".

Within Russell's Global Index, the banks sub-sector has returned 14.9% year-to-date and 4.1% month-to-date as of 29 October outperforming the index.

The picture in Europe is even more encouraging, with the banking segment of the Russell Developed Europe Large Cap Index up 22.6% (versus 18% for the wider benchmark). US big banks are also up around 22% over the same period.

But the numbers don't tell the whole story. Lurking below the surface are many cross currents, dangers and opportunities. While I was in the US, one friend confirmed that, while the regional US banks had benefited hugely from the rebound in the US housing market over the last 18 months, these smaller institutions were struggling to keep up that growth rate, especially as the wave of mortgage refinancings slowed again after an early surge.

In Europe the story is equally mixed, with some UK banks starting to report stronger numbers hinting at the resumption of dividends while others (the Co-op and RBS included) struggle with legacy issues.

And on a Europe-wide level, many hedge funds are growing more and more worried about the systemic risks emanating from the Italian banking system.

Last week, consultants at www.check-risk.com issued a note warning of the very real possibility of future banking crises in Italy.

My own sense is that we are mid-way through a three-stage process of renewal. The biggest profits were made by hedge funds back in 2009 and 2010 when they bet the bank' (forgive the pun) on the authorities stopping the systemic institutions from going bust. The quickest money was made here using bank bonds as a speculative instrument.

The next phase is now upon us. It involves a slow and painful process where the regulators tighten the screws and investors start to work out which institutions will be the winners in this brave new world of lower leverage and diminished casino banking (which is increasingly being transferred into hedge funds and other shadow bankers).

Banks will continue to struggle with legacy assets and overweening regulators, but eventually a balance will be found.

Cue the last phase where investors realise there are two investment opportunities. The first stems from heavily regulated mainstream' banks turning into financial versions of utilities, with tightly controlled margins but predictable cash flows, which eventually feed through into dividends.

The second consists of the dwindling band of global swashbucklers who can continue with their casino operations and their huge wholesale businesses, but shorn of legacy assets. Sitting beyond these banks will be another group of institutions, some of which will be banks, some not, that will focus on serving the needs of the wealthy and super-rich.

These could be wealth managers such as St James's Place (or even Hargreaves Lansdown), asset managers (such as Aberdeen), private banks, or even global banks such as HSBC, which derives a massive chunk of its business from commercial, corporate and wealthy investor operations.

Where should you invest now?

What should investors take away from this? My sense is that the very best of the profits have already been taken as investors have realised the big banks won't go bust. Both Jupiter and Henderson boast top-ranked specialist funds in this space (Jupiter Global Financials and Henderson Global Financials), and both are up well over 30% in the last 12 months and over 70% in the last five years.

However, I think both could still have a very good 12 months ahead of them, and you'd be hard pushed to find many better managers than these two.

The key driver behind improved profits at the big financial institutions will probably be continued economic recovery, the largesse of central bankers worldwide, and the sense that the eurozone won't crumble (just yet).

Banks are a simple play on global and regional growth, benefiting as all our ships rise, increasing fee income and boosting profits.

More particularly, I think there's also a chance that the institutions that focus on serving wealthier clients will prosper the most, as income and wealth inequality widens with every passing year and our pensions crisis continues to move from a rock to a hard place!

But be under no illusions, as the recovery grinds ahead, banks big and small will be volatile, heavily affected by sudden mood swings at their regulators. Brewin Dolphin's excellent Edmund Salvesen has a great blog on the subject,where you can find more acronyms crammed into one story than I've ever seen in my life.

Good actively managed fund managers can help you navigate this tricky terrain, but don't be fooled into thinking that all managers add much value.

Jupiter and Henderson have delivered good numbers this year, but you wouldn't have massively underperformed their peers if you'd chosen a fund tracking global financials (such as the MSCI World Financials index), European financials (the STOXX 600 Banking sector index), or a US financials ETF.

The likes of Amundi, Lyxor, Deutsche db X and Source all boast their own banking and financial services ETFs (mostly tracking the MSCI World Financials Index). Returns of 25%-30% in the last 12 months are standard, with total expense ratios (TERs) of 0.25%-0.65%.

Source's Financials S&P US Select Sector ETF (LSE: XLFS) on a TER of 0.3%, and Lyxor's MSCI World Financials Total Return ETF (LSE: FINW) look especially interesting.

In regional terms, the most striking failure has been Asian banking, where China's ongoing challenges have depressed sentiment towards the big regional banks.

My own suspicion is that this wave of negativity will abate fairly soon and we'll see an abrupt reversal in fortunes, in which case Deutsche DBXs MSCI Emerging Markets Financials ETF (LSE: XMEF) might suddenly benefit.

As for the longer term, my suspicion is that more boring, utility-like banks will re-emerge, shorn of their riskier operations (sometimes unwillingly so after central bank pressure) and we'll see the return of the banks as purveyors of steady and growing dividend income.

If that does happen, then the Polar Capital Global Financials investment trust (LSE: PCFT) should be well positioned. It currently trades on a premium of 1.7%. This fund is very focused on generating a long-term sustainable income from financial stocks generally, and banks especially. The current yield is 3%, but there's a decent chance this will grow with time.