Major banks have endured a difficult 12 months as scandals and subsequent fines continue to be reported in the UK and across the pond in the US.
A prime example is HSBC, whose private bank was heavily fined by authorities in Geneva on Thursday following allegations of money laundering, not to mention the huge penalties that have been paid by Lloyds Banking Group, Barclays and the Royal Bank of Scotland since July last year.
As such, it’s unsurprising that many investors have lost faith in banks. However, from a contrarian perspective, does this mean that now is in fact a good time to invest in banks and financials while valuations are cheap?
Talib Sheikh, who co-runs the five FE Crown-rated JP Morgan Multi-Asset Income fund, told FE Trustnet last week that he particularly likes financial equities because they’re both low-priced and expected to do well when interest rates start to rise in the US.
“One can make the case that, as interest rates start to rise, that will probably have a detrimental effect on things like high yield, certainly in the short-term. But, you could argue that financials will probably do quite well in that kind of environment,” he said.
“The other thing that I think is interesting with financials is that the regulatory structure and the regulatory environment they’re subject to makes them attractive. When we look at some of our analysts’ expectations of a company such as Morgan Stanley on a forecastable horizon, the dividend yield on that will be 5 per cent in a few years and it currently pays 1.5 per cent. So there are key opportunities for their dividends to grow from here.”
“Regulators are forcing banks to become much more stable franchises, and we would argue that they offer an attractive dividend yield which has the potential to grow.”
In fact, over the last year, the MSCI World Financials index has outperformed both the FTSE All Share index by 7.84 percentage points, falling behind the MSCI World index by just 1.22 percentage points.
Performance of indices over 1yr
Source: FE Analytics
Not only are financials showing signs of growth, FE Alpha Manager Alex Wright who manages Fidelity Special Values PLC and Fidelity Special Situations says that the relative price-performance of banks specifically is very low compared to its history, and in fact hasn’t altered much since the financial crisis. 
“While you can see from 2008 to 2010 that the valuation was justified because of weak balance sheets and regulation across the sector, I think going forward five years a lot of those regulatory risks have passed or are at least well-known, expected and provisioned for,” Wright (pictured) said.
“When you look at balance sheets now, they’re considerably stronger than they have been over the last few years. Those capital ratios have really built up.”
“Lloyds in particular has an incredibly strong balance sheet today with what I would argue is excess capital, which will give them the ability to have quite a high dividend yield, given their relatively high level of profitability but reasonably limited growth prospects given their large market share.”
Other stocks that Wright believes are earlier in their “change revolution” and look to be promising are HSBC, Citigroup and Barclays.
However Neil Shillito, director of SG Wealth Management, says investors must realise that banks are unlikely to be the same money making machines that they had been prior to the global financial crisis as the “regulatory revolution” has piled pressure on management teams to alter their behaviour.
“The FCA have taken a few years to wake up but they’ve finally realised that actually you’ve got to alter the behaviour of the board of directors and then everything else will cascade down,” he said.
“You’ve got to start investing in businesses where you believe that the turnaround is starting to happen - I think it’s important for investors to understand that you’re not investing in banks the way they are today, you’re investing in the way they’re going to be in three years’ time.”
In contrast, Martin Bamford, chartered financial planner and managing director of Informed Choice, believes that the easing of regulatory pressure from the FCA isn’t so much a conscious decision than a case of being “hamstrung” due to the sheer size of many banks.
“This gives them an element of protection from the toughest regulations which could do the most damage to their profits,” he said.
“Regulators know that more regulation is required but are fearful of the economic repercussions of imposing too much regulation on the most financially fragile banks.”
Despite holding a less-than-positive view of the practices that many banks adopt, Bamford admits that they are still worth holding.
“If there is one thing banks are very good at doing, other than behaving in a generally nefarious fashion, it’s making profit for shareholders,” he pointed out.
“We are always surprised at how quickly banks are able to bounce back from the latest scandal, fine or market crash. Banks have a privileged position in the global economy which can make them a much safer bet for investors than many other business types.
“The global financial crisis of 2007/08 appears have to cleaned up some of the worst excesses in the banking sector and resulted in a more stable outlook for the future, although investors still need to choose carefully. There’s a big difference between the risk profile of retail and investment banking, so investors have to understand the business model first and know where profits are coming from.”
A good way for investors to minimize investing in trouble banks is of course to invest in a specialist financials fund or a fund that has a high weighting in the sector.
Wright’s Fidelity Special Situations fund is one of the best examples, as the £2.9bn portfolio holds 37.5 per cent in financials and counts the likes of HSBC, Lloyds, Citigroup Barclays and Bank of Ireland within his holdings.
Other value focused funds with high exposure to banks include Schroder Recovery and Investec UK Special Situations which both hold bombed out companies such as RBS.
Earlier this year, FE Trustnet spoke to Stephen Message, who runs the five FE Crown-rated Old Mutual UK Equity Income fund. He increased his financials weighting to almost 40 per cent, arguing that many of his peers are at risk of missing out on a swell in dividends from the sector in the future.
Echoing the views of Shillito, he said: “With the banking sector, it’s not all going to be plain sailing - it hasn’t been for the past four or five years. But I think the trend is one of gradual improvement in terms of falling regulatory burdens and greater confidence in their balance sheets.” “That should lead to dividends returning over the next years. I’m really excited about the banking sector because there’s not many dividends there today but I think there will be in the coming years.”
Out of 19 specialist financials funds, Henderson Global Financials has the highest annualised return at 22.04 per cent. It has also outperformed its FTSE World Financials benchmark by 9.34 percentage points over three years, providing a return of 78.5 per cent.
Performance of fund vs benchmark over 3yrs
Source: FE Analytics
Managed by the Henderson Global Equities team, the £64.7m fund’s largest weighting is in banks at 52.3 per cent. It also has an 18.10 per cent weighting in financial services, a 12 per cent weighting in insurance and a 9.7 per cent in life insurance.
The fund, which has also one of the highest Sharpe ratios – which measures risk adjusted performance – within its peer group currently holds the Bank of America, JPMorgan Chase and Lloyds banking group as its top three holdings.
Henderson Global Financials has a clean ongoing charges figure (OCF) of 1.08 per cent and yields 1 per cent.