How the pros are investing in this high-flying sector

Over the past three years one of the best hunting grounds for investors in the UK stock market has been the financials sector.  

Figures from FE Fundinfo show that over that period the FTSE All-Share Financials excluding Investment Companies sector is up 91.4% versus gains of 41.9% and 39.6% for the FTSE All-Share and FTSE 100.

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Interest rate rises from rock-bottom levels in late 2021 proved to be a catalyst for the sector, particularly for the performance of UK banks. Higher interest rates meant that the net interest margin – the difference between what a bank receives in interest from lending money compared with what it pays on its deposits – increased.  

Despite share prices having a good run and a couple of interest rate cuts, many UK fund managers remain bullish. In this piece we explain why, and outline other areas of the financials sector that fund managers are finding value in.

‘Banks are very attractive, provided rates are over 1% or 2%’

Alex Wright, manager of Fidelity Special Values (LSE:FSV), says that despite interest rate falls UK banks will continue to see the benefits of making bigger margins from higher rates.  

Wright told our Insider Interview video series: “UK banks don’t just put all the money that you have in a current account on short-term deposit with the Bank of England.

“Actually what they do is buy the equivalent of five-year bonds, and they do that on a sort of rolling basis. So, it’s been less than five years since interest rates went up. They only really went up in 2022. So, the benefit of that is still coming through in the banks’ earnings until 2027.

“So, yes, interest rates are going down, but you won’t actually see that in the profits of banks until at least 2028 and onwards. So, you’ve still got very good returns, very good dividends and buybacks from the banks in the meantime.”

Wright, who has holdings in Lloyds Banking Group (LSE:LLOY) and NatWest Group (LSE:NWG), added that “as long as interest rates are above 1% or 2%, the banks are able to make a very good return on capital”.

However, Wright acknowledged that banks are no longer as attractively valued as they were when UK rates peaked at 5.25% and prior to their recent strong share price gains.

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Ian Lance, manager of investment trust Temple Bar (LSE:TMPL), has been taking some money out of UK banks, but says such businesses comprise a substantial proportion of his portfolio today.

Recently participating in our Insider Interview series (which you can watch on interactive investor's YouTube channel), Lance told ii: “The most attractive, and one of the most significant parts of the trust at the moment, is financials. We think that, amazingly, even though the great financial crisis was a long time ago, a lot of people were almost scarred by that and virtually swore never to invest in banks again, and therefore they’ve missed a massive change in the industry.

“The industry is so much different from back in 2008. So, we’ve got the opportunity to buy what we think are good businesses at very, very low valuations.”

Lance has taken some profits from NatWest Group (LSE:NWG), but hasn’t sold out completely, with the stock remaining a top 10 holding at the end of July.

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Both Wright and Lance are value investors and seek companies with cheap price tags with plenty of upside potential. However, not all value investors are as bullish on the sector, with Ben Whitmore, of TM Brickwood UK Value, cautioning that valuations are no longer cheap.

Also recently interviewed by interactive investor, Whitmore said “there does seem to be a much fairer valuation applied to them now”, but added that “they might still provide an attractive return from here”.

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Explaining his approach, Whitmore pointed out: “A lot of it is driven by the starting valuation. If the starting valuation is very low, you don’t need much in the way of good news to make a good investment return.”

Nigel Hikmet, co-portfolio manager of Lansdowne Partners Developed Markets, named UK and Irish banks as “one of our highest-conviction ideas at the moment”.

He said: “We believe there are two basic truths of banking that are often forgotten. First, it is an industry that tends to grow at least in line with nominal GDP over time.

“Second, economies of scale are incredibly powerful, both from cost efficiencies – only increasing with artificial intelligence – and because new business flows tend to be less profitable than the sticky stock of customers, rendering new entrant economics poor. As a result, incumbents earn higher returns and gain market share over time, organically or via consolidation.” 

US banks

David Eiswert, manager of the T. Rowe Price Global Focused Growth Equity fund, is finding value across the pond. He points out that financials are a potential sector winner under US President Donald Trump.

“The financials sector, particularly US large-cap banks, is in what we term a ‘good Trump pond’. This means that the Trump administration is likely supportive of these institutions, possibly leading to regulatory changes that could benefit them.

“There’s the possibility of relaxing some of the constraints around capital and other regulatory adjustments. We have optimism about regulatory changes in the financials sector, particularly in the US, that could boost banks – the lack of a traditional credit cycle, along with other factors like government spending and low energy prices, creates a positive environment for financials stocks.”

Among US bank options are The Goldman Sachs Group (NYSE:GS), Bank of America (NYSE:BAC), JPMorgan Chase & Co (NYSE:JPM), Citigroup (NYSE:C), Wells Fargo & Co (NYSE:WFC) and Morgan Stanley (NYSE:MS).

Other ways to play the financials sector

Financials is a broad sector, and as well as banks includes insurance companies and asset managers.   

Brendan Gulston, co-manager of the WS Gresham House UK Multi Cap Income fund favours wealth managers, with holdings in Quilter (LSE:QLT) and Brooks Macdonald (LSE:BRK).

Explaining his rationale, he says: “The UK wealth management sector is a growing market underpinned by structural drivers such as rising household wealth, an advice gap, and government policy, making it a long-term attractive thematic opportunity to deploy capital.”

He adds that the sector has been out of favour due to higher rates and inflationary pressures moderating flows.

Gulston adds: “We believe this transitory dynamic has led to depressed valuations but will be offset by the longer-term structural drivers of asset flows, thereby presenting attractive investment opportunities.”

He holds the insurance firm Sabre Insurance (LSE:SBRE), which Gulston says has a more than 20-year track record as a specialist in motor underwriting.  

He adds: “Due to its sustainable competitive advantage, Sabre has consistently generated attractive margins relative to the insurance industry and pays a substantial dividend.”

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Paul Middleton, a global equity portfolio manager at Mirabaud Asset Management, has a position in CME Group (NASDAQ:CME), the financial exchange. 

“Financials have performed incredibly well, and have begun to flag to us as being expensive. We therefore think it pays to be more selective, and some of the slightly more defensive names stand out to us as looking attractive here.”

For Chris Elliott, portfolio manager of the IFSL Evenlode Global Equity fund, Mastercard (NYSE:MA) and Visa (NYSE:V) are the standout stocks within the financials sector. 

He explains: “The card networks were both formed in the middle of the previous century and have steadily become the dominant players in global digital payments. However, as card penetration has matured, their growth potential has increasingly shifted beyond simple transaction volumes. Both firms are now expanding rapidly into value-added services (VAS), which includes fraud prevention, data analytics, and cross-border settlement tools.

“These services leverage the huge amount of data generated by the existing card network to enable new financial technologies and means of exchange. For both networks, revenues from these services are growing at double the rate of digital transactions. This not only justifies the strategic investment in technology made by both companies but is set to further increase returns on invested capital – the harbinger of capital growth.”

Fund routes into the financials sector

Darius McDermott, managing director at FundCalibre, picked out Polar Capital Global Insurance and Janus Henderson Global Financials as two options for fund investors looking to gain broad exposure to the sector.

He says: “Financials have enjoyed a strong run recently thanks to rising interest rates, which have boosted bank profit margins, and resilient economies that have kept loan demand steady. As long as a recession is avoided, funds specialising in this space can continue to perform well, as a stable or growing economy lifts investor confidence and drives demand for banking, insurance and broader financial services.

“Polar Capital Global Insurance gives investors targeted access to the non-life insurance sector - a specialist and often overlooked part of the market. Insurance is embedded in our daily lives, regardless of the economic cycle, giving this fund strong defensive characteristics. Its long-term track record and focus on quality make it a great diversifier for income and total-return investors alike.

“Henderson Financial Opportunities is another strong option, offering focused global exposure to the sector with a consistent performance track record.”