Financial Attraction

Finding companies whose fortunes are totally uncorrelated to economic or equity market activity is rare and these stocks typically command a premium rating that seldom fits with our value-centric investment philosophy. Our aim is that, over time and through market cycles, the companies we do select are fundamentally strong enough and sufficiently undervalued to generate superior returns for our clients.

Even at a sector level, investor sentiment can have an important bearing on shorter term performance, particularly as average investment horizons become briefer and levels of correlation increase. The poorest performing sectors of 2014 and 2015 – Utilities, Telecom and Materials – delivered the best returns in the first quarter of this year, while the opposite was also true. Alongside Healthcare and Consumer Discretionary, the weakest performer was Financials which lost 2.7% in GBP terms, compared to a gain of 2.7% for the overall market.

Investors' reluctance to hold financial stocks stems from three related factors: First, that depressed energy prices could trigger a wave of energy provider credit defaults. Second, the market fears that a recession is on the horizon, which would damage growth and trigger loan losses across the wider economy. Finally, that persistently low or negative interest rates will make it harder for banks and insurers to make money. The negative sentiment has impacted the equity fund SKAGEN Global, with Financials representing the fund's largest sector exposure at 23.5%, versus 20.4% for the MSCI All Country World index.

Unpopular, under-researched and undervalued companies

Since the market crisis of 2008 the Financials sector has been an attractive hunting ground for value managers, as Knut Gezelius, SKAGEN Global's Lead Portfolio Manager, explains: "Looked at through the lens of our investment philosophy, Financials have undoubtedly been unpopular not only because of their role in causing the crisis but because of the way business models have had to adapt in its aftermath and the lingering nervousness over the health of the global economy. They're often under-researched as a result of the ongoing cuts to sell-side analyst coverage and frequently undervalued given the uncertainty created by the stricter regulatory and capital requirements they face. This has created opportunities."

SKAGEN Global's Financials holdings are diversified by industry, with holdings across banking, insurance and real estate, and by geography, across both developed and emerging markets. Over half of the fund's Financials exposure is through AIG and Citigroup, the two US giants at the epicentre of the 2008 crisis; the composite insurer, AIG, is the fund's largest holding at 6.9% while, Citi, the banking conglomerate represents the fund's third biggest position at 5.9% of the portfolio.

Together they account for a third of SKAGEN Global's US exposure and are examples of where we have been able to find value in an expensive market, although we remain significantly underweight our benchmark*. Despite the holdings suffering share price losses so far this year as a result of the sector headwinds, our confidence in both remains strong and we expect the stocks to perform better once investors' nervousness subsides.

AIG's shares fell 12% in the first quarter to $54 but we have retained our $90 target price, representing 67% upside, as Gezelius explains: "AIG continues to deliver in line with our investment hypothesis. It has shed non-core assets and returned a significant amount of capital to investors. Although it has struggled to improve its underwriting, the recent addition of two activist investors to the Board should instil greater urgency to address this and also boosts the chances of further, transformational asset sales, which would benefit investors."

Citigroup suffered an even steeper fall over the first quarter with its shares dropping 19% to $42, despite limited exposure to the energy sector and the bank having a strongly diversified international footprint. The team believe it has similar upside potential to AIG from current levels and have used the recent share price weakness to increase their exposure, as Gezelius explains: "Citi's latest results confirmed the underlying improvement we've been looking for with stable revenues, lower costs and a smaller asset base boosting cash generation, which should be returned to shareholders without diminishing earnings power. The bank also has a strong emerging markets franchise, which we believe is a positive for future growth."

MSCI AC World Financials P/B ratio

Source: Bloomberg, as at 31/12/15

Despite financial stocks representing six of the ten largest detractors in the first quarter this year, Gezelius remains confident in the sector's fundamentals and outlook: "We invest for the long-term and with book valuations so undemanding on a historical basis, there are clear opportunities to generate attractive return on equity. First, if companies can continue to move swiftly and seize efficiency initiatives, they should benefit from scale and meet onerous supervisory and capital requirements that will limit the growth potential of challengers. Second, there is an obvious appeal to investors of owning highly regulated finance providers to the largest corporations in an increasingly complex and dangerous world."

Risk emphasis

In addition to financial companies generally being less complex and risky propositions post-crisis, investors can take comfort from the strong risk management embedded within the SKAGEN Global fund's investment process. Although we are active stock-pickers, the portfolio managers perform top-down stress testing of the portfolio under different scenarios and at a holding level they set bear case price targets alongside base case equivalents, as Gezelius explains: "When we enter any new position we typically look for potential upside of at least 30% over two years with possible downside limited to 15%. Only when the base-to-bear case ratio increases above 3:1 will we look to significantly scale up a position."

The fund's focus on value and risk management has thus far seen it steer clear of FinTech companies where stretched valuations arguably imply greater downside risk than upside potential for investors. "As happened following the bursting of the tech bubble, established financial institutions may well end up buying the FinTech winners and shareholders should benefit from combining newer technologies with the strength and large customer bases of traditional banks and insurers", Gezelius argues.

As the world has slowly normalised since the financial crisis many financial firms have built up substantial capital buffers and with state control either behind them or in the process of being reduced, companies are free to allocate or distribute this as they wish. The new normal of heightened regulatory oversight also means that the risk profiles of these much simplified businesses has improved while, assuming we avoid a global recession, their earnings potential remains significant. For the investors that select the right companies, the opportunities remain compelling.

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* SKAGEN Global has a US underweight vs. the MSCI All Country World Index of 13%

All figures as at 31 March 2016 in GBP unless otherwise stated