Why 'left for dead' financial space could still have value

Portfolio manager details points of strength for North American banks and life insurers even as they trade at discounts

Why 'left for dead' financial space could still have value

Given the concerns surrounding the pandemic-induced recession, massive increases in credit losses, concerns about zero-rate monetary policies, and echoes of the 2008 financial crisis that are ringing loud today, investors might think that North American banks and life insurers are not ideal to invest in at the moment. But according to an update on the sector from Brompton Funds, they may deserve a second look.

“The 2008 crisis was different,” said Michael Clare, vice president and portfolio manager at Brompton Funds, in a video presentation on the sector. “It was a crisis that originated in the financial sector. Banks had used a lot of leverage to buy risky assets, which spiraled out of control … It turned into a solvency issue, which saw many financial institutions pushed into bankruptcy or acquired for pennies on the dollar.”

The scenario today, he said, is a pandemic-induced halt in economic activity that’s created a liquidity crisis as businesses and consumers may be temporarily unable to make payments on their loans. But there are several reasons why this may not devolve into a solvency crisis like what happened before.

“A number of regulatory changes have forced the banks to raise capital levels over the past decade or so,” Clare said, noting that banks have become much better capitalized since the events of 2008. Banks have also become more profitable, he said, allowing them to withstand higher loan-loss provisions.

Clare noted that in spite of significant upticks in provisions for credit losses seen over the past two quarters, banks’ capitalization levels have remained strong, with U.S. banks’ capitalization actually increasing compared to the beginning of the year through the second quarter and levels for the Big Six being flat in the fiscal third quarter compared to the beginning of the year.

And while life insurers have traditionally been extremely sensitive to declining interest rates, Clare said they’ve taken steps to make themselves more robust. The estimated impact of a 50-basis-point decline in interest rates on Canada’s four largest lifecos’ book values today, he said, would be a mild decrease of 0.4% on average, compared to an estimated 2.8% decrease in book value estimated for the same decline in interest rates during 2008 conditions.

Aside from introducing shifts in their business mix, Clare said lifecos have been cutting operational costs and repricing premiums of certain products to account for persistently low and declining rates. Their management teams have also become more effective at resolving mismatches in the duration of their assets and liabilities through hedging and strategic portfolio allocations. The upshot, he said, has been persistently higher and more stable return on equity over the period from 2013 to 2020, compared to those seen in the four years following the financial crisis.

The unprecedented scale and swiftness of action from governments and central banks, he added have been beneficial for the banks as consumers continued to make payments and specific measures were enacted to protect the banking sector. And with sector valuations at record lows coupled with a history of seasonal strength during the fall for financials, he said financial companies are hard to ignore.

Based on Bloomberg data as of September 23, Clare said banks are trading near record discounts relative to their benchmarks – the S&P 500 for U.S. banks and the TSX for Canadian banks – in spite of their higher capital levels and improved profitability. The same story emerged for the big four Canadian lifecos, with P/E values for the sector showing a discount relative to the TSX.

“We think the sector has been left for dead a little bit over the past decade or so as investors have been attracted to more growth-y sectors like technology,” Clare said. “We do think the market has been ignoring the improvement we’ve seen in the fundamentals, and … we’ll see some reversion [in valuations] back to the mean.”


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