Polar Capital Global Financials Trust (PCFT) has announced its annual results for the year ended 30 November 2018. In what the chairman’s statement describes as a topsy-turvy year for global equity markets, PCFT provided NAV and share price total returns of -1.5% and -1.7% respectively, which it says compares against a total return for its benchmark, the MSCI World Financials + Real Estate Net Total Return Index, of -0.1%.
A topsy-turvy year
Investment performance was reportedly strong in the first three months, albeit PCFT gave this back over the remainder of the year as European financials, where the Trust has a higher weighting than the benchmark, sold off and conversely real-estate investment trusts (REITs) rallied. PCFT’s managers, Nick Brind and John Yakas, say that the underperformance was driven by an underweight position in Japan and overweight positioning in Europe, partially offset by good stock selection. Currency was also a small headwind for performance reflecting a lower weighting to the US dollar.
The managers say that the biggest contributors to performance in part reflected the fact that US financials had performed relatively well globally while European financials had performed extremely poorly. As a result, PCFT’s best performing holdings included Mastercard, the payments company, JP Morgan, the Trust’s largest holding, and Bank of America. The biggest detractors included ING Groep, the Dutch bank and also one of the largest holdings in the Trust’s portfolio, BNP Paribas, the French bank and Santander, the Spanish banking group.
Nick and John are known for providing a comprehensive statement that is well worth a read. We have included extracts on performance and outlook below.
Managers’ commentary on performance
“The year ended 30 November 2018 was a disappointing one for equity markets and only sterling’s weakness against the US dollar resulted it in being a reasonably positive one for UK investors. It was a particularly frustrating period for the financials sector which fell 0.1% over the course of the year under review as illustrated by our benchmark index, the MSCI World Financials Index + Real Estate Net Total Return Index. Against this background the Trust’s net asset value total return over the period was -1.5%.
Investment performance was strong in the first three months, albeit we gave back this performance over the remainder of the year as European financials, where the Trust has a higher weighting than our benchmark, sold off and conversely real-estate investment trusts (REITs) rallied. The underperformance was driven by an underweight position in Japan and overweight positioning in Europe, as highlighted above, partially offset by good stock selection. Currency was also a small headwind for performance reflecting a lower weighting to the US dollar.
The biggest contributors to performance in part reflected the fact that US financials had performed relatively well globally while European financials had performed extremely poorly. As a result, the Trust’s best performing holdings included Mastercard, the payments company, JP Morgan, the Trust’s largest holding, and Bank of America. The biggest detractors included ING Groep, the Dutch bank and also one of the largest holdings in the Trust’s portfolio, BNP Paribas, the French bank and Santander, the Spanish banking group.”
Managers commentary on outlook’
“Looking back, the reasons for the banking sector’s underperformance post the financial crisis up until a couple of years ago are easily understandable. The significant increase in capital requirements, regulatory costs, conduct issues and litigation, on top of a shallower economic recovery than previous cycles and finally an interest rate environment that has put significant pressure on net interest margins together are unprecedented.
But the degree of underperformance against underlying equity markets over the last year looks anomalous. Valuations have fallen sharply. For example, US, European and Japanese banks have seen their valuations on a P/E basis for 2019 fall by between 25-40% to less than 9.0x, 7.7x and 7.1x respectively, suggesting a far more substantial fall in earnings over the next few years than we believe is likely.
Nevertheless, in the short-term there is a lack of catalysts for banks to rerate until the outlook stabilises. US and European banks, where the largest percentage of the portfolio resides, have produced steady results with US banks seeing a significant boost to their earnings from the fall in corporate tax rates. Loan growth though has not picked up as expected, with increased competition in the US from non-bank lenders.
Asset quality, outside some emerging markets such as India and Turkey, remains resilient and, if anything, has continued to surprise by being better than expected, reflecting the relatively benign macro background. It is likely that in the next downturn more losses will occur off-balance sheets where direct or non-bank lenders have taken on more risk than banks as the latter no longer want to take certain risks or are no longer allowed by regulators to do so.
The underlying trend of banks continuing to return capital to shareholders through buybacks and dividends has continued and with significantly more clarity on the outlook for capital requirement this should help to underpin sentiment towards the banking sector. Bank balance sheets remain solid, particularly in the US where one would have to go back to the 1930s to find a time when banks had more capital than they do today.
In the US, after receiving Senate approval, the House of Representatives, earlier in the year, approved a series of banking reforms which roll back part of the Dodd-Frank post financial crisis legislation and continues a trend of gradual easing in financial regulation. One of the key aspects of the bill is a reform to increase the threshold for a bank to qualify as systemically important (raised to US$250bn in assets from US$50bn previously) which will materially reduce the cost of regulation for smaller banks.
Over the next couple of years, we expect to see a pick-up in M&A activity in the US. There are still around 5,000 banks in the US, a reduction from some 12,000 prior to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which lifted the restrictions on banks operating across state borders. One of the key drivers for increased activity will be the need for smaller banks to compete with their much larger peers where they are being outspent on technology. Mergers between large banks remain unlikely.
We remain constructive on the sector and while the short-term outlook remains uncertain and the sector is not without risk, it is vastly better capitalised than the last time it went into a downturn and shares have fallen to extremely low levels so offering tremendous value. The Trust is not just invested in the banking sector, but as the majority of the portfolio is invested there, that will be the key driver of performance.
The Financial Times’ influential Lex Column discussing US banks in December stated, “The banks’ harshest critics worry that the economy is slowing. If so, that will trigger the dual effects of both the Fed backing off rate rises in 2019 and increasing losses. But the probability of this worst-case scenario does not quite match up with such low equity valuations. Unless one just hates the banks”.
As if on cue, in January, the Federal Reserve backed down on its hawkish commentary about interest rates and the speed with which it would reduce its balance sheet. Equity markets have rallied sharply and with them financial shares have performed well. Nevertheless, the rally has not removed the large discount the sector trades at to the underlying equity market and we would argue that even if not hated the sector remains unloved, undervalued and misunderstood.”