Have Financials Already Had Their Moment?

Featuring

Murdo MacLean

From

Related Article

Text transcript

Murdo MacLean, I’m a client investment manager here at Walter Scott & Partners.

Financials have historically not really played a big part or featured very prominently in our portfolios. And there are certainly some reasons that I’ll come onto to touch upon as to why that’s the case. I think just to the question, certainly, since the latter part of 2020, the banking sector share price really across the world, but obviously in the U.S. particularly has seen sort of reinvigoration, shall we say, following on from rather a long period of stagnation. And in that, I mean relative to other parts of the economic landscape.

And driving this, there’s certainly been optimism around the prospects of an economic recovery, and also an appreciation that some of these securities, some of these companies were trading on relatively low valuations, hence, when the prospects of a recovery in their fundamentals are presenting themselves, then that makes it look quite attractive for a period of time. Usually, we see either the fundamentals don’t play out like that, or the valuation re-rates to a level where no longer do they appear quite as attractive, and that tends to play out.

Now, certainly, banks and financials more widely do thrive in periods where economic growth is robust as that tends to drive loan demand, and interest rates typically follow and might increase, and that will improve the profitability of the other loan book. Now, I think in the U.S., certainly, the relatively robust post-Covid economic recovery and the potential prospect of an eventual Fed tapering has definitely acted as a catalyst in this case.

And we saw even in the first quarter results that some of those larger banks did see trading and investment banking operations drive very strong year-on-year profit expansion. That being said, actual underlying loan growth hasn’t been that impressive. And I think that’s one of the factors that we always feel when we look at and then analyze banks is that very often, the underlying loan growth or loan momentum is overshadowed either positively or negatively by the investment banking division.

And when we come to analyze that particular part of banking institutions it’s almost entirely impossible to do so. It’s a virtual black box, and it’s certainly very difficult to project into the future what investment banking revenues and momentum might be like. So I think it’s right to say that, yes, banks do remain still noticeably absent from our portfolios. It’s certainly not the case that we’ve ever argued that these businesses will not have their moment in the sun. But we’ve also not changed our opinion that the area itself is a relatively fallow, shall we say, hunting ground for us. What we’re looking for, effectively, are businesses that carry relatively low balance sheet risk, and that we can quantify that. And we would prefer those businesses to be generating high returns over the long term on what we would consider to be relatively ungeared capital. So high return businesses generating that from reinvesting in their business. And that funding of that reinvestment should be coming from internal cash flow rather than borrowing. We have seen evidence in the last couple of months that that has somewhat run out of steam, shall we say, in terms of the trade of late. We’ve not seen the potential relative headwinds to performance that we saw at the end of 2020 and the beginning of 2021 from that particular backdrop. And I think that just reflects the fact that the market is once again focusing on the fundamentals of businesses, the relative quality versus growth and valuation.

We’re looking at these businesses really more in terms of where will they be in the next five and 10 years, rather than where will they be next quarter or where they are today. And so with that in mind, we’re clearly exposed to and find more often exciting ideas in parts of the economy that we think are going to be more important in the next five and 10 years. So it’s no surprise that we find a greater selection of information technology businesses in the portfolio, particularly as IT and technology proliferates more and more parts of our lives. That gives you even more of a variety of businesses in the IT sector that you can invest in, and that are subject to lots of different growth factors around the world.

Same goes for health care, with the clear benefits of greater longevity for people around the world that brings with it, obviously, the potential for more diseases, but also for more wear and tear on the body, and the respective care that will be required for that. And then as such, again, we’re seeing more and more opportunities in the health-care space. And those are just two spaces that I think we’ve long been of the view that would become a very significant part of our portfolio, albeit driven by the bottom-up approach.

We found that the pandemic, but more importantly, the longer-lasting effects of the pandemic, will be supportive to many businesses that were already planning for the future — that are exposed and embracing and utilizing technology, that are helping people in terms of living longer, living more comfortably, or that are embracing technology or otherwise in terms of being a retailer or in fact, in terms of embracing or allowing more automation in the workplace as people do less labour-intensive roles in the future.