Invesco Perpetual’s head of UK equities, Mark Barnett, explains why he’s positive about opportunities in financials, the UK’s largest stock market sector, but not yet by mainstream banks.
The London Stock Exchange, property companies, insurers, asset managers, wealth managers and of course, banks – such are the kinds of companies which define the interestingly diverse UK financials sector of the FTSE All-Share index, an area where over the years I have unearthed some rewarding long term investments and continue to find investment opportunities. My focus is on companies which adapt quickly to the changing financial landscape, which embrace and deploy new technology so as to maximise customer satisfaction, minimise costs, and help sustain future profit growth.
Around a quarter of each of the UK portfolios that I manage are currently invested in companies that reside in the financials sector and I am often asked how this is so – how is it is that they are overweight in financials yet have had no exposure to conventional banks since 2007, which themselves represent over a third, by value, of the financials sector? What is it that attracts me to certain other companies and sub-sectors within the financials rather than banks? And how has this portfolio bias within the sector played out historically? And what of the future? How will the growth of unconventional lending (peer-to-peer (P2P)) and much tighter banking regulation impact the financial landscape?
To answer all these questions, I thought it would be helpful to explain what I see as the significant attractions of the many “non-banks” financials that have earned a place in the portfolios I manage – both in isolation and relative to the UK’s conventional banks which continue to dominate the financials sector in terms of media coverage and brand awareness, but not necessarily in share price performance.
When is a bank not a bank?
In September, around the seventh anniversary of the collapse of Lehman Brothers, the Financial Times (FT) ran a story on UK banks, accompanied by a graph showing the lacklustre share price performance of the major UK banks since 2008. There were no banks in the portfolios that I managed at the time, unless one classifies Provident Financial as a bank which, in some respects it is, albeit officially it resides in the financial services sub-section of the financials sector. Figure 2 below shows the share price performance of the major banks as highlighted by the FT, versus the FTSE All-Share index and with the addition Provident Financial. I introduced Provident Financial to the portfolios I was managing in 2008 and it continues to earn a place in the portfolios I manage today.
Whilst Provident Financial has many similarities to a bank – it can take deposits, has a banking licence and lends money to consumers, there were a number of factors which drew me to invest in this company back in 2008. First, it had a dominant market position built up over many decades in a specialist niche that the major banks preferred to overlook, namely that of non-standard lending – this afforded the company superior pricing power. Second, its smaller size, UK focus and relative simplicity made it possible for me to conduct extensive due diligence and get comfortable with the long-term earnings and dividend growth outlook. Third, I was impressed by what struck me as a shrewd and experienced management team. Over the last seven years the company has grown both profits and dividends, yet has also reinvested in the business and in expansion, taking advantage of new technologies, making inroads into online lending, and extending its product offering and customer reach both organically and through acquisition. In short, Provident Financial is a company which differentiates itself well and has carved out a niche where barriers to entry are now arguably quite high, whilst profit margins remain robust. The company has a history dating back to 1880, but financial dinosaur it is not. It has been quick to adapt to changes in the financial landscape.
You can see from Figure 3 that performance over time can be quite differentiated amongst the sub-sectors showing that the overall financials category is a very broad church.
A changing financial landscape
The collapse of Lehman Brothers in 2008 and the radical changes to the world’s financial landscape that ensued have given rise to an era of much tighter regulation in order to prevent such
a crisis happening again. At the same time, many of the major banks have been hamstrung with varying degrees of bad debt and excessive leverage. This has hampered UK banks’ ability to pay out dividends and also their willingness to lend. This in turn has encouraged borrowers to explore other means of borrowing and new lenders to emerge with lower cost, more entrepreneurial business models.
The so-called ‘challenger’ banks such as Virgin Money and Metrobank have made their mark, but remain a relatively small portion of the banking sector and face the same stringent regulatory environment as the older and larger incumbents. The competitive environment is further intensified by the fact that a number of UK asset managers have recently expanded into loan provision, most notably Legal & General, a company traditionally focused on UK life insurance, which I introduced across the portfolios in early 2014, and which has in recent years been broadening its product offering by focusing on upscaling other areas of its business such as asset management, capitalising on its long established brand and global reach.
But perhaps the most innovative development has come from the growth of peer-to-peer (P2P) lending platforms, where entities are not subject to banking regulation, yet are in a position to offer similar products to that of banks, with lower overheads. P2P lenders argue that their credit scoring technology is as good as the banks’, if not more granular, while their turnaround of business is much faster. Because they do not need to hold regulatory capital or liquid assets, operate physical branches or deal with outdated legacy IT systems, their costs of making and administering small short-term loans are much lower than for banks.
Given its relative infancy, there are few means of investing in this area in the quoted space. I have accumulated holdings in P2P Global and VPC Specialty Lending in the portfolios, two investment companies which provide the loan capital indirectly to consumers and small businesses via P2P platforms.
Portfolios well represented in nonlife insurers and real estate investment companies
Elsewhere in the financials sector I have found what I believe are compelling long-term investment opportunities in both nonlife insurance and real estate investment companies. The nonlife insurance sector has generated significant special dividend payments in recent years as the lack of catastrophe losses has allowed historic reserves to be released. Companies operating within the Lloyd’s insurance market syndicates are seen as having strategic value as evidenced by the recent bid for Amlin by Mitsui of Japan at a significant premium to the prevailing market price and I see scope for further consolidation in this investment niche. Apart from Amlin, the portfolios have holdings in Beazley, Hiscox and Lancashire.
With regard to real estate investments, the main holdings within the portfolios comprise Derwent London and Shaftesbury. These mid cap sized property companies have strong, proven management teams with local knowledge and expertise. They are active managers of their assets and I believe they can offer both a rising dividend stream based on growing rental income and their reversionary yield potential. the leader
Another financial company in which the portfolios are invested is the London Stock Exchange (LSE). Founded over 300 years ago the LSE has stood the test of time and continues to be at the heart of the global financial stage. LSE has a dominant market position and a diversified business mix. It offers real time pricing and reference information services worldwide for its major indices – generating an attractive and reliable stream of publishing revenues. The company has benefitted from the growth of exchange traded funds which has continued to drive revenues for the exchange. In addition the company has further recurring revenue streams derived from its ownership of both the FTSE and Russell indices. The latter was acquired in 2014 and in my view this has resulted in both a broader range of products and a larger potential client pool to sell to, not only in the more mature US and European markets but also in China, where FTSE already has a dominant position.
Providing access to Britain’s rich intellectual capital heritage and capacity for innovation
Another area in the financials sector where I see long-term earnings growth potential is in intellectual property companies (IPC), which form part of the “financial services” sub sector. Portfoilio holdings IP Group and Imperial Innovations, have relationships with a spread of academic institutions and specialise in the commercialisation of research ideas from these universities. The investments in these companies ensure, I believe, that the portfolios are strongly placed to benefit from the commercialisation of intellectual property.
Continuing to keep a watching brief on banks
As can be seen from the diverse array of companies mentioned in this article and from Figures 1 & 3, the constituents of the FTSE All-Share financials sector are not a homogenous group. Whilst banks make up the largest single component of the financials sector by value, they have not performed well in share price terms in recent years as illustrated in Figure 4 below. Whilst I have not yet been inclined to add conventional banks to the portfolios, I continue to keep a watching brief.
And what of the future?
The financial landscape is shifting in favour of tailored customer solutions. Mobile banking, on-line lending, more sophisticated credit scoring and more flexible savings products are all evidence of this trend. Whilst the major banks have not stood still, they have been preoccupied with the legacy of the 2008 global financial crisis and the way has been opened for lower cost more innovative operators to take advantage of newly emerging technologies, whether they have been around for over 100 years (Provident Financial) or just over a decade in the case of Victory Park Capital, manager of VPC Specialty Lending
The financials sector comprises a diverse range of companies from across the market cap spectrum and whilst banks remain a key part of that sector in terms of size, they are not where I have been finding the best opportunities in recent years.