Unlocking the potential in beat-up sectors

A pair of portfolio managers see opportunities in two areas affected by the pandemic

Unlocking the potential in beat-up sectors

We all know the toll COVID-19 has taken on the economy and specific sectors. While some areas managed to recover, others are still lagging. Yet, for the portfolio managers at Harvest Portfolios, that lag may equal opportunity in specific sectors: utilities and US banks.

When it comes to utilities, it has been a tale of two stories in 2020. The months before the virus took hold were positive for the sector. Yet, much like the broader market, the asset class got dragged down by the pandemic. “Utilities were doing quite well because bond yields were at low levels and that pushed up valuations in low volatility assets, so utilities benefited,” explained Mike Dragosits, portfolio manager, Harvest Portfolios. “In normal recessions, utilities tend to hold up better, but there was panic as the pandemic set in and concerns that customers were not going to be able to pay their bills.  This dragged down many utilities and utility like sectors more than would be expected in a normal recession. It made the valuations cheaper and now they are setting up attractively. Things have settled and their steady and high cash flows should bring investors seeking income back to the asset class over time.”

The US bank sector has seen its own set of challenges from low interest rates, weak loan growth and elevated loan/loss provisions that have put pressure on earnings. “It has been tough for the broader banking sector as many of the business lines and ways banks make money have been challenged because of the macro environment for loans and the current interest rate environment.  The larger diversified banks have been able to offset a bit of the volatility because they have some operations that have been performing, such as capital markets operations, but not enough to completely offset the challenges elsewhere.    However, now they are trading at historically attractive valuations. The speed and magnitude of the recovery in bank shares is likely to be a balance between the velocity of economic recovery versus the headwinds of the current interest rate environment and loan loss uncertainty,” says James Learmonth, senior portfolio manager, Harvest Portfolios.

While both Dragosits and Learmonth say the main catalyst has been COVID-19, they do point to other issues in each sector.  When it comes to the US banks, Learmonth says it has been a difficult period since the 2008 financial crisis as stricter capital rules and regulations have come into place. Add to that the long-term decline in interest rates and the challenges are amplified. “Since the crisis, we have also seen a trend of deleveraging consumer balance sheets. These and other factors have contributed to the poor sentiment towards banks that has been exacerbated by the pandemic.”

As for utilities, it is sentiment towards the sector has largely been affected by COVID. For Harvest, they have seen that spill into other sectors in their utilities fund like telecoms and pipelines, whose challenges add to the overall issues facing the sector. “Telecoms have been impacted similar to utilities, especially in Europe, but headwinds on growth, dividend policies and regulation could be setting up for potential  value. With the pipeline companies, that sector is driven by oil and gas which has been a tough area. The valuation compressions for pipelines is most apparent. I would consider the asset class a deep value class. Yields on pipeline names are attractive and the business model is a steady, growing model. There is a transition to renewables but that will take decades. Oil and gas are here to stay, and I think there is opportunity on the deep value side,” added Dragosits.

That shift to renewables is also something that Dragosits feels plays into the long-term viability of the utilities sector. “The big theme for utilities is ESG investing and decarbonization. Our portfolio is not entirely renewable focused at this point, but we will see these companies decarbonize their operations. The new projects are almost all renewable. We will get to that renewable-focused utility sector over the long term and I think that is one of the big themes investors are looking at.”

In terms of the US banks, Learmonth says the valuations are historically attractive from both a price to book value and dividend yield basis but uncertainty is making them a tougher longer-term play. “We think there is potential for a short to intermediate term rally as we gain clarity on the economic outlook in the coming months. To see it realized, we probably need to see stress test results that confirm the banks are in solid capital positions. Banks in the U.S. have been subjected to dividend caps and share buyback suspensions by the Federal Reserve, those are in place until at least the end of 2020, but if the economic environment continues to improve and the Fed gets comfort that the banks won’t be swamped with loan losses, having the buybacks and dividend growth re-established for the group will help sentiment.  We would expect share prices to respond positively to less uncertainty.”

Learmonth added that with the increased monetary and fiscal stimulus seen, and possibly more coming, a stronger economy could lead to a reduction in loan loss allowances and stronger loan growth. Higher growth and inflation expectations could also lead to a steepening yield curve and give some reprieve on net interest margins, a catalyst for earnings growth to surprise to the upside.

While each sector is dealing with their own challenges, they do provide their own unique opportunities. Learmonth does see the US banks as a short-term opportunity, with the possibility of a sustained tradeable rally. Still, he adds that for investors looking to gain exposure to the space, diversification is important. That is why he favours something like Harvest’s US Bank Leaders Income ETF (HUBL), because it provides exposure to a pool of 15 US financial stocks, primarily focused on the bank industry. It also employs Harvest’s covered call strategy to enhance the underlying dividend yield of the portfolio. “In this uncertain environment it makes sense to use a diversified approach to the industry and the covered call strategy can generate additional cash flow as we wait for these positive catalysts to emerge.”

Meanwhile for Dragosits, utilities look more like a long-term play as he believes interest rates will remain low, and investors will turn to the sector for yield and sustainability. Harvest offers their Harvest Equal Weight Global Utilities Income ETF (HUTL), which similar to HUBL, is a well-diversified option with a covered call strategy. They use a formula to pick 30 of the largest higher yielding stocks in utilities, telecom and pipelines in Canada, the US and Western Europe. “We end up with a globally diversified mix of names in the subsectors.  We think it isolates and diversifies for investors and reduces things like regional specific, natural disasters and political risks. Owning the basket gives diversity while investors seeking the relatively high income the sector offers are rewarded with additional monthly cash flows from the covered call strategy.”