In the initial, vertiginous recovery phase of equity markets of 2009, banks were at the vanguard - the top performing global sector between March and June 2009. By the last quarter of that year, banks were the worst performing sector, that quarter, ushered in a period of underperformance that eventually flattened off in 2011.
A burst of outperformance in 2012 has since been fully ceded and, over the whole period of measurement, banks have performed a handful of percentage points below the global equity index.
So why do we like banks? Partly on account of the fact that others do not. The weight of moral opprobrium that has been shipped in the banks’ direction makes them unpopular investments to hold, particularly in a world where quality consumer stocks have outperformed so handsomely.
Their past failings are relevant. Public and political ire got its reckoning in the form of additional taxation and further regulatory restrictions. From a fundamental perspective, this meant two things: banks’ return on equity (ROE) was curtailed as risky but profitable activities were outlawed or punished via heavier capital requirements, but it also meant that banks have been de-risked, at least partially.
The de-risking process does not mean that banks profits have been denuded: JP Morgan, one of the best investment banks, earns an ROE of 10.2% versus the global average ROE for all companies of 10.3%. Wells Fargo, one of the best consumer focused banks in America, earns 12.9%.
And as we observe the new laws and regulations in action, whilst some are still being rolled out, the legislative onslaught is abating and no new actions are underway. The pendulum having fully swung, the industry outlook should stabilise from here.
The second broad reason to like banks at this stage in the cycle is that lending intentions of credit officers are picking up in the US, in Europe and in Japan. Once the surge in re-mortgage activity in the US ebbed, the sluggishness of conventional lending has been a feature of the post crisis years.
A number of factors explain this: the dulling effect on lending appetites that comes from debt work-outs, the pro-cyclical manner in which the regulators have rounded on banks, the general confusion with regard to extraordinary monetary policy, companies’ appetite and willingness to take advantage of very flat curves by issuing bonds and re-terming their liabilities.
We infer that many of these dragging factors are on the wane.
The third reason that we like banks is that their valuations do not imply much optimism about their future growth rates so, as investment instruments, they contain positive optionality. The global universe is trading below book value and the best loved banking franchises are little more than 1.5x book value: cheap if compared to the global sector’s 20 year average rating of 1.8 book. Previous peak cycle multiples are almost certainly unobtainable given the generally mute tenor of economic growth and the removal of the flightier profit opportunities but average cycle ratings are, we think, plausible.
The final question is how best to invest in this theme. For our portfolios we operate an equally weighted basked of the largest five US commercial banks (excluding Goldman Sachs as they are principally an investment bank).
We have augmented this with an ETF which tracks the continental European banking sector (we like Europe more than the UK as the UK’s economic cycle is more entrenched and advanced, Europe’s is still doubted). We have over 3% in Japanese financials via our Japanese equity holdings and a small exposure in China. In aggregate, we have 15% of our portfolio invested in banks around the world.