Nick Brind and John Yakas, co-managers of Polar Capital Global Financials Trust, look at whether investor pessimism in the banking sector is still valid.
A decade after banks hit their lows, sentiment towards the sector has once again turned sharply negative. Most bank shares are now at a 40%-plus discount to broader equity markets, which is significantly larger than their historic levels. This is despite the huge amount of work, led by regulators and legislators over this period, making the banking sector far stronger, more stable and therefore more attractive to investors today. So, is the current pessimism misplaced or still valid?
The crisis led to a concerted effort by governments and regulators worldwide to ensure individual banks were run as financially stronger businesses. Today, however, expectations for interest rates to be cut from their already low levels, against a background of relatively lacklustre economic growth, has resulted in markets expecting a weaker outlook for the sector. Therefore, at best, share prices have lagged the underlying equity market, or at worst fallen in absolute terms.
Nevertheless, we believe investors are hugely overestimating the risks. Years of very little loan growth, much tougher regulation and stronger balance sheets all suggest a banking system that is well placed to weather a downturn. The amount of capital a bank is obliged to hold to compensate for the risk of individuals or companies defaulting on loans is now at multi-year highs. Lloyds Bank, for example, now holds twice as much capital as it did in 2008.
Another change we have seen in the past decade is a huge shift to digital banking, with many commentators talking about the risk the sector suffers in the same way as retailers have thanks to technology-led disruption, in this case from fintech companies. But investors are underestimating the ability of traditional banks to compete in this area, to outspend new entrants and cut costs, alongside the fact that the regulatory advantage start-ups are likely to have will be eroded as they grow.
Ten years on, a more boring banking sector is what makes the financial sector overall a much more attractive proposition today. It is made more attractive when coupled with the high level of capital return via dividends and buybacks they offer. Maybe we will have to go through another downturn for investors to finally believe that risks have reduced, and that any slowdown may well be the catalyst for a recovery in the sector.
As John Maynard Keynes said: “When the facts change, I change my mind. What do you do, sir?”
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