Portfolio manager says investors are acting like it's 2008 but argues banks, lifecos are in better shape
Our human tendency to fight the last crisis means North American financials are mispriced, according to one portfolio manager.
Financials have been under pressure in 2020, primarily because of investor fears over two issues: that the pandemic-induced recession will drive a significant increase in credit losses and that banks and lifecos will suffer because of low interest rates, which often reduce margins and reduce profitability.
However, Mike Clare, VP and portfolio manager at Brompton Funds, who manages the Brompton North American Financials Dividend ETF, urged investors to look at banks’ price-to-tangible-book value (PTBV), which he told WP is back to about where it was at the lows in 2009.
He said: “We're going through the first major recession since the 2008 financial crisis and I always get the sense that the last crisis is always fresh on people's minds when you go through the next crisis. The market is treating financials as though we're going through a 2008-style crisis again but there are key differences.”
Clare explained that the last crisis originated in the financial sector, with the banks spending many years using increasing leverage to buy risky assets before it spiralled out of control. The result, infamously, was major solvency issues and the bankruptcy of the likes of Lehman Brothers, while others were acquired for pennies on the dollar.
This is different. There is no solvency crisis but a potential liquidity problem, which can be fixed by government regulators or fiscal stimulus. Clare argued that banks are also much better positioned than they were in 2008, both from a profitability and a capital perspective, to withstand higher credit losses.
He said: “Yet, the sector's trading about as cheap as it was at the lows in 2009 and that doesn't really jive with me – something’s out of whack. Either we're going to have higher credit losses, which I don't think is the case, or banks’ value will rebound higher at some point, and that's probably going to take time.”
The portfolio manager added that the life insurance sector also suffers from a common misconception that they're extremely sensitive to interest rates. Historically, this has been the case because of long duration liabilities. A plan can last for several decades but the invested assets have a much shorter duration, creating a mismatch where it’s hurt by declining rates and aided by rising rates.
Clare said lifecos have taken steps to reduce this mismatch by shifting the business mix to products with less rate sensitivity, like wealth management products and the repricing of existing life insurance contracts.
He explained: “If you look back to the 2009-2012 timeframe, when rates dropped to zero, the four big Canadian lifecos were earning on average for that period a return on equity of about 6.5% - and that was bouncing around quite a bit. But if you look at 2013 to 2020, that's improved to 11.6% on average, and it hasn't bounced around nearly as much.
“These steps they've taken to reduce sensitivity to interest rates have really shown up in terms of better and more consistent returns – and that’s not being reflected in valuation.”
He added: “There’s a lot of fear around financials because, as investors and as human beings, we are subject to behavioural biases. We tend to fight the last crisis and for the financial sector, it’s just not as bad as it was in 2008. I think the whole sector is mispriced.”
Fall is a period where Canadian financials in particular do well, traditionally outperforming in September, October and November. But Brompton’s ETF is not just made up of banks and lifecos, providing exposure to fintech, credit card companies and exchanges. It owns CME Group, which runs exchanges like Chicago Mercantile Exchange, while Clare said a lot of derivatives exchanges do well with increased volatile.
Another holding, S&P Global, has become a big data play. Clare said: “They own S&P indices and license them to the ETF providers that want to use SP in the name. Those [type of] businesses are becoming more of recurring revenue model, as opposed to a model that's subject to cycles and exposure to interest rates and credit losses. The market tends to place higher multiples on recurring revenues and so those sectors and stocks have done better than the rest of financials.”