Interactive Investor

Why some fund managers love bank shares, but Terry Smith steers clear

24th May 2023 10:39

by Sam Benstead from interactive investor

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Banks are making more money due to higher interest rates, but that does not necessarily make them good investments, writes Sam Benstead.

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Rising interest rates should spell great news for bank shares, and in turn boost share prices. Their “net interest margin”, which is the difference between the interest income they receive from making loans and the interest they pay out on deposits, increases when rates rise, therefore boosting profits.

And this is what has happened, with UK banks reported huge profit increases for the first three months of the year.

But not all fund managers are convinced that more profit makes banks better investments. Terry Smith, the Fundsmith Equity manager, penned an opinion piece for the Financial Times explaining why he never invests in bank companies.

One of his key reasons was that they use gearing (leverage) to increase the value of their assets compared with the value of their deposits. He also said that bank runs are possible, and healthy banks can be brought down by their more risk-hungry peers. The 3.8% weighting in Smith's portfolio to financials comes from payments processor Visa (NYSE:V) rather than a banking or insurance stock.

But lots of fund managers back the sector, and as financials is the largest portion of the FTSE 100 at 18.7%, so do passive investment fans.

On the whole, the recent high-profile collapses of Credit Suisse (SIX:CSGN) and Silicon Valley Bank has not put the pros off banking shares. The consensus among investors is that bank issues are confined to just a handful of companies, rather than something that will spread to the entire banking system.

One active fund manager who likes the sector is Ian Lance, co-fund manager of Temple Bar Investment Trust, which counts NatWest and Standard Chartered, and Citigroup in its portfolio. He has spoken out against investors such as Terry Smith who shun the sector.

“Some fund managers well known for their quality growth style of investing, have suggested that this proves that banks as an industry are ‘uninvestable’. Many of them were saying the same about the energy sector a few years ago and this has subsequently been the best-performing sector for the last two years,” he said.

Lance says that returns are not too low to compensate investors because the price paid for shares matters, and banking shares are very cheap.  

“When businesses change hands at fractions of their book value, the price paid for ownership can amplify or dampen the returns investors ultimately reap. Simply dismissing a business model out of hand, without paying attention to the price at which that business is on sale is an abdication of one of the key responsibilities of an active manager,” he said.

He also argues that looking at leverage alone is too simplistic.

“While leverage brings with it risks, it is important to consider what companies do with the process of that leverage, and how they employ it in the context of a wider business model, before reaching conclusions about how risky that borrowing really is. After all, freight trucks have much larger engines than Ferraris but don’t travel at speeds that endanger the driver nearly as much.

“Looking at default rates by sector observes that banking has one of the lowest cumulative default rates over a 10-year horizon at 4.2%, while durable consumer goods, retail and healthcare sat at 25.6%, 24.3% and 10.4%, respectively, all sporting far higher risks for investors.

“Leverage requires caution, and bank management teams proceeding without caution can wound shareholders. The same, however, is true of all business models.”

Lance also argues that there is no evidence that banks are being disrupted by financial technology (fintech) firms, and instead banks are incorporating new technology into their services, and strong banks are not susceptible to bank runs. He adds that Warren Buffett is a big investor in banks, so they are in good company.

Another fan of the banking sector is Alex Wright, manager of the Super 60-rated Fidelity Special Values investment trust.

Financials form the biggest part of his UK trust, with banks NatWest and Barclays in the top 10 positions.

Wright said: “Higher interest rates have allowed banks to significantly improve their profitability at a time where earnings in many industries are under pressure, yet many investors continue to avoid them because they are scarred from the 2008 global financial crisis.

“However, UK and Irish banks have become far higher-quality businesses since the changes to the regulatory environment over the past decade. They have strengthened their balance sheets, trimmed bloated cost bases, and pulled back from riskier lending.”

Furthermore, he says that banks are subject to robust regulatory frameworks, transparent accounting practices and have diversified deposit structures.

“Some of these attributes were absent from several smaller regional US banks and at Credit Suisse, leading to recent negative headlines and outcomes for investors in these companies,” he said.

Finally, he argues that banks should also be more resilient to a downturn as a result of these higher profits and, while they may experience some defaults on loans, it provides them with a strong buffer.

Wright’s largest holding is Irish bank AIB Group, which he says is profiting from higher interest rates and is also the beneficiary of an improvement in Ireland’s banking market, where the number of competing groups has recently shrunk from five to three.

The performance of British bank shares this year has been mixed. Barclays shares have fallen 2%, while NatWest, Standard Chartered and Lloyds shares are flat, and HSBC is up 15%.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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