Polar Capital Global Financials (PCFT) has announced its annual results for the year ended 30 November 2022. During the period, PCFT provided a positive NAV total return of 1.9% although, reflecting a widening of its discount, it provided a share price total return of -7.6%. In comparison, the MSCI ACWI Financials provided a total return of 6.8%. PCFT’s chairman, Robert Kyprianou, comments that against a backdrop for the year of Covid-related health concerns being replaced by headlines of a war in Europe; post-Covid supply disruptions; the return of inflation; and, not just the end of whatever-it-takes quantitative easing (QE), but a 180 degree policy reversal by major central banks in favour of raising rates and quantitative tightening (QT), there were few places to hide. He is therefore pleased to report a positive net asset value (NAV) total return, further growth in the issued share capital of the Company, and an increase in the dividend. PCFT’s was helped by a decline in sterling and the value attributes of much of the financials sector.
Dividend and revenue outlook
For the last two financial years, PCFT maintained its total dividend at 4.40p per ordinary share by drawing on distributable reserves built up in previous years. In August 2022, PCFT paid an unchanged first interim dividend for the current financial year of 2.40p per ordinary share. PCFT’s chairman comments that, although income from investments began to recover as the world economy opened up following an easing of the Covid pandemic, distributable reserves were required once again to support the August 2022 dividend. However, on 18 January 2023, PCFT announced a second interim dividend for the 2022 financial year of 2.05p per ordinary share payable on 28 February 2023, bringing the total dividend for the financial year to 4.45p. This being a small increase on previous years. This second interim dividend was almost fully covered by earnings in the period, requiring minor support from distributable reserves.
Looking ahead, PCFT’s manager has discretion to invest up to 10% of the portfolio in fixed income securities and the trust’s chairman says that the recent rise in bond yields presents an opportunity to increase revenues from this source. The recent trend in distributions from the underlying equity holdings has been positive as well. However, the chairman cautions that, looking forward, further growth in PCFT’s dividend distribution remains uncertain given brewing economic headwinds.
Management team
PCFT’s portfolio is currently co-managed by Nick Brind, John Yakas and George Barrow. As announced on 14 February 2023, John Yakas will be retiring from Polar Capital with effect from 30 June 2023 and stepping back to an advisory role. The team responsible for the management of the portfolio has significant experience of investing in the financial sector having grown both its size, from three to five since the Company’s inception in 2013, as well as the assets for which they are responsible. As part of the transition process, George Barrow, who has been part of the team since 2008, was named co-manager in 2020.
Investment managers’ comments on performance
“Equity markets fell over the period under review (1 December 2021 to 30 November 2022) as the impact of rising interest rates, further lockdowns in China, Russia’s invasion of Ukraine and the resulting impact on energy prices, and volatility in the UK gilts market hit sentiment and more than offset better corporate earnings. The strength of the US dollar cushioned falls for sterling investors, as did a late rally in equity markets in October and November.
“Government bonds fell sharply over the year as the US Federal Reserve, European and other central banks raised interest rates at a faster pace than previously expected. However, concern about the impact on the outlook for growth resulted in the US yield curve inverting (when the interest rate on long term bonds is lower than that on shorter dated bonds), to levels not seen since the early 1980s, a historically good predictor of recessions.
“Against this background, financials outperformed wider equity markets. During the 12 months, the Trust’s net asset value total return rose 1.9%, while its benchmark index, the MSCI All Country World Financials Net Total Return Index, rose 6.8%. In contrast, global equity markets, as illustrated by the MSCI All Country World Total Return Index, fell 1.4% and the Lipper open-ended peer group of financial equity sector funds fell 0.3%. Since launch, the Trust’s net asset value has returned 125.9% against the MSCI All Country World Financials Net Total Return Index return of 123.4% and the Lipper open-ended peer group return of 97.6%.
“Notwithstanding the good performance of the sector and that the Trust’s net asset value outperformed its peers and wider equity markets, relative performance was disappointing. The Trust’s outperformance versus its peers, we believe, was probably due to the Trust’s lower exposure to FinTech companies which performed poorly, and higher exposure to insurance companies, which performed extremely strongly over the period.
“While we had strong performance from our holdings in the insurance sector – Arch Capital and Beazley both benefited from large rises in their share prices – the Trust’s large overweight holding in faster-growing, smaller US banks more than offset this and was the most significant drag on performance relative to benchmark, along with a holding in PayPal Holdings.
“Underweight exposure to commodity-exporting countries such as Australia, Saudi Arabia, Brazil and South Africa, but also Japan, impacted performance and more than offset positive contributions from the positioning in the likes of the UK, Indonesia and Ireland. Gearing was a small positive contributor to performance while currency and fixed income were small negative contributors, with exposure to fixed income having been reduced materially in recent years.”
Investment managers’ sector review
“At the beginning of the period, financials saw significant outperformance. This was led by banks, but also insurance companies due to the positive correlation they have with higher bond yields, in anticipation that it would boost the earnings of banks as yields on their loans rise faster than what they had to pay out on deposits. However, banks gave up that outperformance as investors pulled back from the subsector with concerns about the outlook for growth, following the invasion of Ukraine, and therefore the increased risk of higher loan losses which would act as a headwind to earnings.
“Equally, diversified financials, where we are underweight the benchmark, also struggled to perform against this background. While the subsector covers a broad spectrum of companies, from stock exchanges, asset managers and investment banks to information service companies, those that are more sensitive to the level of financial markets – in particular asset managers – suffered sharp share price falls as fund flows turned negative and expectations for performance fees and future fund raises fell. Investment banks were also weak in anticipation of lower activity in capital markets.
“Conversely, non-life insurance companies proved far more resilient. First, they are more defensive, being less economically sensitive as insurance losses are for the most part driven by weather-related losses and accidents. Second, insurance rates continued to increase faster than claims costs, albeit with exceptions including UK motor insurance. Third, like banks, they are a beneficiary of rising interest rates and bond yields as this increases their investment income.
“FinTech companies were extremely weak over the period, primarily due to very high valuations coming under significant pressure as discount rates increased and disappointment around earnings, while regulatory concerns impacted the ‘buy now/pay later’ sector. This also reflected broader weakness in the technology sector, with unprofitable companies the worst affected and some large, well-known unquoted FinTech businesses seeing significant falls in their valuations, while others saw their business models questioned.”
Investment managers’ comments on Investment activity
“At the beginning of the reporting period, the Trust’s investment portfolio was positioned in the expectation that growth would remain respectable, as economies continued to open up post-Covid and rising interest rates and bond yields would be a boost for banks’ earnings and therefore share prices. Consequently, the portfolio was overweight banking stocks, notably faster-growing, smaller regional banks in the US which we saw as the biggest beneficiary of this trend.
“Gearing had already been reduced to 5.2% at the end of November 2021 from a high of 12.7% in November 2020, reflecting the fact that valuations had risen sharply over the preceding 12 months. However, with the onset of war in Ukraine, rises in commodity prices and concerns around the impact on growth of rising interest rates, we positioned the portfolio more defensively. As a result, the proportion of the portfolio in banks was reduced by close to seven percentage points, largely through a reduction in our holdings in US and European banks, while exposure to more defensive companies within the sector, such as non-life insurers, was increased.
“The shift to a more defensive portfolio was also reflected in individual stock positioning. For example, new holdings were purchased in, among others, Visa, Intact Financial Corporation, Marsh McLennan and Royal Bank of Canada, while we added to holdings in Berkshire Hathaway, Chubb and Wells Fargo. All of these are seen as more defensive, with insurance companies and Visa being less economically sensitive while the two banks are seen as more defensive when compared to their peers, the former in part due to the resilience of the Canadian economy. We also added to holdings in other commodity-driven economies such as Norway and Indonesia for the same reasons.
“Conversely, holdings in JPMorgan, Citizens Financial Group, UBS Group, SVB Financial Group and Signature Bank – all seen as more sensitive to volatility in financial markets – were reduced, and the residual holdings in the latter two were sold later in the period. Holdings in Intesa Sanpaolo and ING Groep, both European banks, were sold as the proximity of the war to Europe led us to reduce our European bank exposure in the expectation it would have a significant impact on the region, albeit the banks have performed much better than we expected at the time of the invasion.
“With equity markets suffering significant weakness at the end of September, we started to reverse some of the more defensive positioning as we felt financial markets were discounting a much deeper downturn than was justified. This was done through a combination of; adding to our holdings in JPMorgan, HSBC and Toronto-Dominion; starting new holdings in, among others, AIB Group and BOC Hong Kong; selling holdings in Baloise Holding, First Republic Bank and Shinhan Financial Group: reducing holdings such as Arch Capital, Berkshire Hathaway and Western Alliance.
“We remained underweight asset managers and reduced our holding in Blackstone, the US alternative asset manager which suffered from having to cap redemptions from its listed property fund. We sold the remaining position later in the year in preference for a holding in Ares Management, which we perceived as more defensive. Alternative asset managers are an area we like for the long term due to the locked-up capital on which they earn fees and demand for underlying asset classes. In the short term, we saw risks around their ability to continue to grow at the pace they have in recent years.
“In Asia, we continue to have a large overweight to Indian private sector banks which continue to see attractive growth. We do not invest in state banks as we do not believe they are good underwriters of risk. We made small changes to our holdings in AIA Group and Hong Kong Exchanges and Clearing which we saw as beneficiaries of China relaxing its zero-Covid policy, while adding to our holding in Prudential which should also be a beneficiary.
“In Indonesia and Malaysia, both commodity-boosted economies, we added to holdings in Bank Central Asia and Bank Rakyat Indonesia Persero and started a new position in Hong Leong Bank. This was partially offset by reductions in our exposure to Thailand, an economy which has struggled as tourism and domestic consumption has been impacted by the delayed reopening of China and less government support during Covid.
“The reinsurance sector has had a difficult few years, as a succession of natural disasters and other losses led to disappointing returns. During the year, a number of companies in the sector reduced the amount of capital allocated to reinsurance. Consequently, as reinsurance rates were expected to rise sharply, reflecting continued increase in demand for reinsurance due to climate change and inflation, for the first time since the launch of the Trust we also took a small position in Hannover Rueck, a reinsurance company – albeit other holdings in the portfolio with exposure to reinsurance would also benefit.
“At inception close to 10% of the Company’s portfolio was invested in fixed income securities, primarily to generate extra income. These holdings were for the most part sold in recent years as the yields on offer fell and became much less attractive. However, with the back-up in yields in 2022, we significantly increased exposure in October and November acquiring new holdings in bonds issued by, for example, AIB Group, IG Group Holdings, Nationwide Building Society, Legal & General Group, Rothesay Life and BNP Paribas at yields of between 8% and 12%.
“We have been cautious of investing in unquoted companies in the past few years, in part as valuations appeared very unattractive but also as we saw better value in listed companies, especially with the fall in equity markets during the pandemic. Nevertheless, we did participate in a fund raising for Moneybox, a UK wealth and savings platform, in February 2022 which we believe has exciting potential.
“Gearing, which dropped at one point during the middle of the year to a position where we had net cash available, ended the period at 6%.”
Investment managers’ comments on outlook
“Looking forward, we remain very constructive on the outlook for financials, despite the shorter-term uncertainties which would argue for caution in a sector that is cyclical. Today, banks are more robust with significantly greater levels of capital and liquidity than before the global financial crisis. Importantly, their risk appetite coming into this downturn is at a level which would suggest much lower loan losses. In plain English, banks have made far fewer bad loans than they have in previous cycles.
“Furthermore, banks have been benefiting from the rise in interest rates which has led to their net interest margins widening, that is to say the interest income they earn on loans has increased faster than the increase in what they have to pay out on savings accounts. Despite inflationary pressures, costs have been contained at a manageable level. Consequently bank earnings have risen over the year as analysts have had to factor in the changing interest rate environment. For some banks this has been significant, albeit not enough in many cases to offset weaker sentiment resulting in bank stocks derating.
“The unknowns looking forward for bank investors will be the degree and duration of the downturn and therefore the cost to bank profitability. There are good reasons to believe loan losses will be modest, but this is complicated by the fact that the amount of loan loss provisions banks will have to set aside is likely to be larger than the actual losses due to accounting rules. As we saw during the pandemic, this led to banks taking significantly more loan loss provisions than they needed as the majority were written back when bad debts did not increase to the extent expected.
“A cautious investor may look at the rise in interest rates and inflation, anecdotal stories of individuals and small businesses struggling with bills, the inversion of the yield curve, swill the tea leaves and quite reasonably assume that the downturn will be severe. Conversely, the evidence so far shows that savings built up during the pandemic and more robust corporate balance sheets, plus help from governments to offset increased energy costs, has allowed consumers and corporates to withstand the slowdown which explains why delinquencies have not yet risen meaningfully. The increase in loan loss provisions seen in recent results announcements does not undermine this view as it is driven by accounting rules.
“The uncertainty is whether the banking sector will see further weakness along with wider equity markets, in anticipation that the downturn will be more severe than that priced in by financial markets, before recovering as investors realise this is not a repeat of the global financial crisis or the early 1990s downturn. Or do investors start to see through the shorter-term weakness and see the value in buying banking shares and bid up share prices to reflect their longer-term value and earnings potential?
“Unlike the banking sector, where investors have understandably stepped back as they see risks of a recession impacting short-term earnings and have for the most part ignored the longer-term improvement in their earnings from higher interest rates, for non-life insurance companies, investors are willing to look through the shorter-term impact to their earnings. We have been very constructive on the non-life insurance sector and continue to be, though we are conscious that its performance as described above was in part due to its defensive characteristics.
“However, with non-life insurance companies there has also been a material improvement in underlying earnings, from better underwriting returns, due to higher insurance premiums relative to claims costs as well as higher investment income. Understandably, investors have willingly paid a higher multiple for that stream of earnings. Reinsurance companies that write property-catastrophe insurance and other risks have equally performed well despite 2022 being a poor year for returns, as reinsurance premium rates have risen sharply.
“We continue to remain cautious on asset managers and investment banks, the former as, notwithstanding the recent rally in financial markets, we believe flows will likely continue to remain weak, and in the latter as they rely on activity in capital markets which we believe will be slow to recover. We own shares in MSCI and S&P Global as beneficiaries of the continued demand for ETFs and demand for data and services across their product areas, in the latter instance as a credit rating agency.
“As highlighted in the interim report to the end of May 2022, S&P and MSCI, which compile many US and global indices, include FinTech companies within the technology sector not the financial sector. Any investments in this area continue to be off-benchmark and effectively result in us having an overweight position. However, they have announced that they will be moving certain payment companies, notably PayPal Holdings, Visa and Mastercard, into the financial sector indices in March this year.
“The portfolio remains overweight banking stocks, albeit by not as much as this time last year, where we see material upside in share prices. Otherwise, broadly the portfolio remains positioned in more defensive areas of the sector, notably non-life insurance, payments, fixed income securities and information services companies. Nevertheless, we have increased our exposure to Asia to benefit from the recovery of China’s self-imposed zero-Covid policies as well as Europe, at the expense of the US. Gearing has also increased by a couple of percentage points.
“The rally in financial markets over the last few months on the back of lower energy prices, in particular, in Europe, and softer inflation data has increased the probability of a shallower downturn and led to hopes of a “soft landing”. Financials outperformed wider equity markets in both 2021 and 2022 and if this proves to be correct we would expect them to extend this outperformance for a third consecutive year. However, much will depend on how central banks react to the more positive data on inflation. Furthermore, will inflation come down quickly, as implied by financial markets, or will it prove to be more stubborn as history would suggest, albeit history is largely from the 1970s and 1980s when unions had greater power? Either way, we believe the next 10 years will be far better for the financials sector now the era of cheap money has ended.”