Financial stocks are set to fly as we recover from the pandemic
The banking and insurance sectors are probably the world’s least popular apart from coal mining, says Jonathan Compton. The industry may face pervasive change, but the stocks look too cheap
Even hermits have heard of the collapses of Australia’s Greensill Capital, named after its founder Lex Greensill; America’s Archegos Capital (named from the Greek word for “leader” by its founder, Bill Hwang); and Germany’s Wirecard AG – a tiny casualty in the 2000 dotcom crash, then recapitalised in a reverse takeover by its CEO, Markus Braun.
Each of these men was a middle-management unknown claiming to have reinvented arcane areas of finance using new technology – which no-one questioned – to create eye-watering profits. Each was a consummate networker whose smooth sales patter attracted influential names from politics and business, creating a snowball effect. And each was leveraged to the hilt.
What intrigues me most is why some of the largest and theoretically most savvy banks in the world lined up to shovel ever more money into gaping black holes. This incompetence will do little to change the perception following the 2008 crash that banks and finance companies are unreformed gamblers. Yet despite these losses and rapid change throughout the sector, the investment case for banks is compelling.
Still too big to fail
After the 2008 meltdown in the global financial system the mantra was that no bank should ever again be “too big to fail”. In reality the big boys are still gobbling up the weak. A maximum of five banks dominate in every country. America is about to witness a frenzy of banking takeovers. Small challenger banks, sponsored by governments, were meant to shake up the market by taking on the established players. The UK is a leader in this regard, as well as in “fintech” – tech-driven financial services.
But these developments haven’t dislodged the dominant banks. This is a sector predisposed towards producing big beasts. In finance, size brings advantages, spreading costs and providing economies of scale in technology and compliance. The largest challenger is Virgin Money, an agglomeration of unloved banks whose assets are worth about 7% of those held by the UK’s No.2, Barclays. The assets of all challengers and fintechs amount to less than the Nationwide Building Society’s; it is the seventh-largest traditional bank.
Attracting customers with special offers is easy; making them profitable is not. Nor are the challengers cleaner than the behemoths. Metro Bank in 2018 was found to have mis-classified loans, thus breaching capital adequacy rules while the then-chairman had paid his wife’s firm at least £20m for design work on hideous colour schemes. N26, Germany’s largest online challenger, has been told by the German financial regulator, BaFin, to improve its IT systems to prevent money laundering.
Lex, Bill and Marcus highlight yet again the incompetence of the regulators and ineffectiveness of new regulations. So large and cumbersome are these (more rules were created between 2009 and 2015 than in the previous 200 years) that, perversely, it makes them easier to avoid. In the case of Wirecard, BaFin, the government and the Bundesbank threatened to prosecute the journalists who lifted the lid on its fantasy accounts.
Banks will always be unstable because of the genuine genius of fractional banking. Early bankers realised that depositors were unlikely to withdraw their money simultaneously, so only a fraction of deposits are backed by cash. The excess deposits are then used to lend, invest or speculate. Fractional banking is always at risk from a sudden loss of confidence, worsened by stupid loans or borrowing from the wholesale markets (in other words, other financial institutions), which can suddenly cut off credit. This helped bring down our introductory trio and, earlier, Northern Rock. Yet banking is changing at breakneck speed. The consequent uncertainty is one reason why many banks are dirt cheap.
Fintech is finding its feet
New tech-savvy competitors are one threat. Even at the turn of the century banks were wedded to the one-stop shop model, cross-selling a range of financial products. It never worked because the products were often poor and overpriced. New tech disrupters, sometimes selling a single product, have stolen much bread-and-butter business. Wise, for instance, founded in London in 2011, is an international money-transfer company. Its first-year turnover was £8m. Last year sales reached £4bn – per month.
Similar firms are murdering the high-fee, low-service foreign-exchange business of mainstream banks. Six-year-old Revolut is solely a tech-bank. It offers many financial services, is expanding overseas and already has an estimated 16 million customers. These new companies specialise in providing user-friendly and instant access via mobile phone or tablet, keen pricing and transparent fees. For anyone with any technical nous and anyone under 45, transferring money, or buying insurance or shares with lengthy paperwork at the branch of your local bank, is anathema.
The technology problem is also internal as most banks underinvested for decades. As a result, every takeover leads to a collapse in their computer systems. Having been bought by Spain’s Banco Sabadell in 2015, TSB’s future was destroyed in 2018 by a botched IT “migration” costing over £200m in reparations. Sabadell has forlornly sought a buyer, but has no chance of recouping its £1.7bn purchase price.
Yet the greatest threats to incumbent banks lie elsewhere. The core business of banks remains lending out their depositors’ money. The key metric in this respect is the “net interest margin”, or NIM, the difference between the interest rate paid on deposits and the rate charged for loans. With near-zero interest rates and fierce competition, NIMs are tight; witness the many sub-inflation mortgage offerings.
Worse, shadow banking has taken away much of banks’ core business. Providing finance for projects was once the exclusive preserve of banks. No longer. Non-bank finance and shadow banking is not dodgy geezers offering loans in cash, but rather pension funds, insurers and private-equity groups putting their spare money to better use. So my local solar farm, for example, was financed by pension funds and has been bought by an insurance company that needs a reliable income stream. Another major threat to banking is digital currencies. Cryptocurrencies’ underlying technology – blockchain, the digital ledger – is of potentially enormous value in terms of speed, security and traceability.
Central banks and governments have belatedly realised that they are potentially losing control of money and payments systems, not to crypto bandits, but to foreign giants and non-banks beyond their remit, such as Amazon or Google. Big Tech is seeking to develop blockchain technology; no wonder, then, that the major central banks are urgently looking into “central bank digital currencies”, or CBDCs (see page 16). These are hugely controversial, as potentially the blockchain allows governments to be aware of – or stop – your every financial transaction (hence China is trying to develop CBDCs as fast as possible), while in theory making the prime raison d’être for banks – taking deposits – more redundant than steam trains.
Poor sentiment has produced bargains
So why invest in banks? One reason is that they are cheap for no good financial reason save historic sentiment, trading well below book value, a good test of cheapness. Loan-to-deposit ratios are at prudent levels. After the shock of 2008, much higher reserve requirements have been imposed to act as buffers against any downturn; balance sheets have rarely been stronger. Scandals notwithstanding, risk controls have slowly improved: artificial intelligence has the potential to make them better still. With technology, banks are belatedly playing catch-up, hiring staff better trained in coding and computer skills. JPMorgan spends $11bn a year on technology. A fifth of its 225,000 staff are technologists. Others have realised they must follow. The advantage of the disrupters is ebbing.
Controversially perhaps, banks have had a huge windfall from the pandemic. Only the large incumbents could process government support. They kept economies ticking over. But at the same time the smarter banks realised their business models could and must change more quickly. Trends before the pandemic, such as home-working, will now race ahead. Branches will be closed at record rates, whatever the grumbles from politicians. Many are divesting whole business lines where profitability has been poor. The one-stop shop is truly dead.
For years banks have struggled to deliver on promises to reduce their cost-to-income ratios. Costs are dominated by staff and premises; fewer branches mean fewer staff and premises. Today the skylines of many major cities are dominated by trophy headquarters and financial skyscrapers such as NatWest Tower or Canary Wharf in London. Many, if not most, are redundant. The potential impact on costs and profits is spectacular.
Finally, there are five bonuses around the corner. Banks can be winners from the likely return of inflation: as bond yields rise so their NIMs should improve. Secondly, as the pandemic ends, demand for loans for housing, other durables and business is recovering sharply. Yet the real profit boost will come from (unusually) prudent loan-loss provisions. Many banks were over-providing for loan losses pre-pandemic. Provisions increased sharply, but as they are written back, profits will soar. Moreover, many banks have considerable surplus capital. The scope for large and rising dividends is the best of any sector. Finally, the advantages of incumbency are enormous.
What next for insurers?
By contrast, the outlook for the other half of finance – insurance – is less clear. This sector suffers from many of the same threats as banks, but has fewer options. Insurance is about pricing risk, so it is the most data-intensive industry on the planet. Insurers are giant tech firms. The problem is that many are very dozy giant tech firms. The property and casualty business of insurance companies accounts for about one-third of their global premiums (or income), but less than a third is comprehensively computerised.
A Deloitte survey of 32 UK insurance firms found a clear correlation between profitability and technology talent, and that the UK was lagging behind in attracting and retaining skilled staff. Only a quarter of employees possess digital or analytical skills, with a mere 12% of staff employed in these two roles. Yet over half of all staff in international tech giants have these skills, with a third in digital or analytical roles. Insurance brokers are even worse. A mere 6% of their staff are employed in digital or analytic jobs.
Change is coming. Globally, surveys show about a third of all insurance companies are looking to sell off less profitable/non-core businesses and to ramp up their technology expenditure and increase their merger and takeover activity, often to acquire such expertise. The spur for change is nimble new tech companies using big data, the better to price risk, policies and pay out faster.
In the UK “insuretechs”, such as FloodFlash, use algorithms to anticipate flooding and after the recent Yorkshire floods the firm was paying out within ten hours. Wrisk provides rapid and flexible car insurance. In America companies such as Hippo (home insurance), Lemonade (insurance for tenants) or Oscar (health) are eating the larger companies’ core businesses. As if this were not enough, insurance companies are compelled to hold large capital reserves to cover future payouts, much of which has to be held in the highest-rated bonds. These yield nothing. Cyberattacks, increasing climate and ecological risks and a tougher approach by many courts are all difficult headwinds.
But it’s not all gloom. Insurers are adept at raising premiums and shrugging off huge losses. They are also clever at selling you products you didn’t know you needed. Millions of travellers will buy “plague cover” now that it is less urgent to do so. Takeover activity will be rife and will bolster stocks. Capital buffers and reserves are high and the scope for chunky dividends is almost as good as at the banks. And some will adapt, ditch their arcane practices and make better use of data and tools they already own. The banking and insurance sectors are probably the world’s least popular, except perhaps for coal mining and, unlike many, offer excellent or reasonable value. Lex, Bill and Marcus loved their banking friends, who loved them back. I’m less passionate perhaps but am equally amorous for financial gain from stockmarket anomalies.
What to buy now
Although I have extolled the new technology upstarts, I do not advocate buying any. Most are losing money and I’m not smart enough to distinguish the few swans from the ugly ducklings. For a global spread the sole UK financials investment trust is the Polar Capital Global Financials Trust (LSE: PCFT). Well-diversified with a 2.6% yield (likely to rise fast) and trading on a small premium to net asset value (NAV), it looks a sensible bet.
A more interesting, but riskier trust is the £1.1bn, three year-old Chrysalis Investments (LSE: CHRY), which has a very heavy weighting towards unlisted fintech-related companies before they come to market. Performance has been good, yet it trades on a 3% discount to NAV. The negative, in my view, is the egregious performance fee. There is a large range of insurance equity funds. The best-performing is also run by Polar Capital, the Polar Capital Global Insurance Fund F class. Since 2010 the NAV has handsomely exceeded its benchmark and index.
Because I believe the value and gains in financials are clear and probable respectively and many of the best opportunities lie in the underperforming and beaten-up UK market, I prefer individual stocks that are large household names. The big six UK banks have put aside £96bn for loan losses, twice their already high pre-pandemic levels, and hold £32bn of excess capital.
Their credit models will all but force them to release these by way of dividends and/or buybacks. Firstly, consider Barclays Bank (LSE: BARC). This is despite its paranoid CEO who was fined £642,000 by the Financial Conduct Authority, the City regulator, in 2018 for trying to hunt down a whistleblower. The most recent quarterly results beat analysts’ forecasts by a third and its Tier I ratio – or capital buffer – is a whopping 14.6% of risk-weighted assets. Barclays has proved European banks can make money from global investment banking and plain vanilla, basic banking.
Lloyds Banking Group (LSE: LLOY) is entirely plain vanilla with an even higher Tier I ratio of 16.1%. It, too, reported sharply higher first-quarter profits of £1,283m, an increase of 60%. I have been buying both at prices above and below today’s levels. Like Lloyds, NatWest (LSE: NWG) was also bailed out by the government, whose 60% stake will act as a drag as it is drip-fed into the market, so the stock requires more patience. It, too, is storming ahead, with first-quarter profits of £964m compared with the consensus expectation of £536m. Of the large UK banks, it appears to be making the fastest progress in upgrading technology and building cybersecurity.
Overseas there are many other opportunities, but given great value at home, why bother? But I do have a large holding in Bank of Ireland (LSE: BIRG). It was mulched in the 2008 meltdown, but is now well capitalised. It and Allied Irish Banks have the Irish market to themselves these days as rivals have disappeared, so they enjoy cartel-like pricing power. I have not given multiples or yields for any of the above because the pandemic has made the former temporarily meaningless. The latter are currently subject to government controls. But around ten times and 4.5% plus are prudent guesses for 2022. All trade well below book value.