Licence to Print Money

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February 13, 2023
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  • The European Banks story is starting to play out as, while Macro Investors continue to speculate on GDP and inflation trades, news flow from corporates means bottom up investors are starting to realise that the end of Zero Interest Rates (ZIRP) means huge improvements in Net Interest Margins (NIMs) for banks, which in turn means huge upgrades in revenues, even without any new loans.
  • Announcements of increased dividends and buybacks (eg Unicredito) have come against a background where, despite some nice moves already, those same banks are still priced for a recession that many are starting to think may not be as bad as first thought, meaning the macro specialists are also starting to rethink.
  • The combination of low valuation, operational leverage, the end of regulatory restrictions on dividends and buybacks and a general improvement in pricing power and competitive advantage is sector wide – and in fact not limited to banks -but for those banks with a deep and rich deposit base it is that NIM story that is the most powerful; having a large deposit base in this new New Normal is, quite literally a License to Print Money.

Back in November, we were excited to meet up with friends and colleagues from Toscafund in London, who were visiting Hong Kong as the restrictions were being finally lifted. We wrote this up as (Money in the banks), because we were particularly taken with the logic behind buying into the ideas in their flagship Toscafund long/short financials fund. To quote (ourselves)

As Hong Kong finally opens up, we had the opportunity to catch up with some of our friends and colleagues from Toscafund who were marketing in Hong Kong for the first time in almost 3 years. In particular, they were talking about their flagship Financials long/short fund and how they were the most interested in European Banks that they have been for many years. While this blog is not about specific investment advice (it is, as they say, for information and hopefully entertainment purposes only) the overlap of interest is that we have added European Banks to our Model Portfolio of smart beta thematics. We are hoping to capture the beta, while they are aiming to add further alpha at both long and short side. Below, we set out the case for Beta in European Banks in 2023, something we see as the equivalent of the energy sector in 2022 – full of cash, unloved, under-owned and with a mis-reading of the macro view based on market muscle memory.
MARKET THINKING, MONEY IN THE BANK(S) NOVEMBER 2022

The return since then has been a pleasing 16% on the SX7P European Banks Index and a 10% rally in the MSCI European Financials. By adding Alpha to that Beta, through both stock selection and the ability to short the losers as well as have exposure to the winners the Tosca Funds have improved on that return (although they don’t publicly quote their returns), so it was thus doubly interesting to have Toscafund founder Martin Hughes in town last week to not only hear how that story was progressing but also to see how the clients are reacting to the story as it shifts from prediction to realisation.

Some remembered the point that the story had resonance to energy stocks a year earlier i.e. a mis-reading of the macro leading to a structural underweight that was contradicted by the bottom up reality of cash flows and dividends that then triggered a panic to ‘get inline’ – and a 70% return in a matter of months. The ones that had already acted were pleased, while the ones that hadn’t even mentioned it to their underlying clients were a bit nervous about what to do next! Others were intrigued and were not unhappy to have missed the first leg, wanting instead to understand how the next phase would play out. The more macro investors have, naturally, tried to tie the story to a view on the macro economy, i.e. because they were more concerned about a slowdown than we were, their underweight the banks would prove to be right when the (in their view) inevitable recession came. And yet,

the story on banks already assumes a recession – the delta is thus on how much better it could get if there isn’t a recession rather than how much worse it will get if there is.

To be honest, after many years on the sell side as a strategist before becoming an investment manager, we weren’t surprised, since this used to happen all the time. If you were early on a story, clients wanted to wait until someone else had bought into it, but then as it played out (hopefully you were correct) they either decided it was too late and thus missed the next leg or announced that they would buy into it when it corrected 10% and watched while it never did. Finally, in order to minimise their tracking error (and thus their personal risk) they would get in at the top. Others, usually those most exposed to Bonds, would have an eeyore-ish view on everything and a reason to be ‘defensive’ at all times, until they too were forced by their need to track the benchmark. This in fact is exactly what inspired Market Thinking as a concept, the behavioural finance aspects that lead to markets, while theoretically being efficient, in fact behaving in ways that continue to offer investment opportunities.

What is still being missed

Psychology remains important; in one meeting Martin scribbled on a piece of paper – “single digit PE, 0.7 of book, strong free cash flow, earnings upgrades, high yield and share buybacks” – noting that this was a winning combination for any investor and one that everyone would eagerly buy into, until he added the final line, Financials, at which point he said that everyone would tend to switch off. This is the market muscle memory we referred to earlier, after more than a decade in which Finanicals have failed to make money and ignoring them (and their complexity) was simply easier than not. This is also the opportunity. As Financials specialists, Tosafund have not had the option of abandoning Financials as ‘too difficult’ and have continued to extract value from financials by focusing on the micro despite the poor macro. Now with the macro favourable they are feeling it is very much ‘their time’.

Banks have been in the ‘too difficult’ box for over a decade. Now looks like time to take them back out. The story is clean, simple and attractive.

From a Market Thinking viewpoint it was fascinating to observe that what is still being missed (by many if not all) remains the Net Interest Margin Story. QE and Zero Interest Rates destroyed Bank’s net interest margins over the last 20 years and simply removing that artificial headwind will turn this around such that revenue growth will go up without any extra volume, even though as Tosca point out, loan growth itself remains a very healthy 4%.

Source Toscafund, Market Thinking

The second point when macro investors try to do equities is that they tend to equate GDP growth with revenue growth and then earnings growth, completely missing the concept of operational leverage and margins. Thus that increase in margins with only a modest increase in volumes can deliver very strong profitability.

Source Toscafund, Market Thinking

As previously discussed, historically a boost to NIMs would be offset by expectations of higher loan/loss provisions, but as we go into this new New Normal the traditional banks have not been lending, or what they have has been higher quality. It’s mostly been done by their competitors, who had access to ultra cheap money, which means that together with guarantees and other provisions based around Covid, balance sheets are much cleaner and stronger.

Bottom Line – winners in the new New Normal

Banks are clear winners in this new New Normal. Normalised interest rates mean that normal companies can make normal profits and good companies can make good profits and given that we are putting rates back to where they ‘should be’, rather than aggressively pushing them higher to deliberately create a credit crash, the provisions that normally accompany higher NIMs are not required. In the meantime, the markets, influenced by Macro traders coming off a great 2022, are not only pricing banks for a recession, but failing to grasp the bottom up realities of margin expansion, operational gearing and the regulatory changes allowing both high dividend payouts and share buybacks. The more that banks like Unicredito make announcements about profits and buybacks, the more that the bottom up story will start to take over. Things don’t move in straight lines, but Tosca think (and we agree) that this story has a lot further to run.

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Model Portfolio Changes

Periodically, we take the opportunity to refresh our portfolio of Themes, incorporating new ideas to replace ones that that we think are no longing offering attractive risk return opportunities. We monitor the new ideas for a period, before incorporating them when we think the risk return is attractive, guided by our confidence scoring systems. As the risk return profile more generally has improved and as we reallocate cash back into our themes, we have added two new themes from our 'watch list' - Japanese Wholesale and Trading Companies and Emerging Markets ex China. The note provides more details and background.

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