James Carthew: Rate fears help case for Polar Capital Global Financials

The prospect of further interest rate rises adds to the uncertainty over the economy but should be positive for this financials fund, which invests in much more than banks.

While there have been no front-page headlines for a few weeks, there still seems to be an undercurrent of concern about the health of the banking sector. The main problem is perceived to be exposure to the commercial property sector, where falling property values could trigger defaults.

However, not all banks are created equal and there is much more to the financial sector than just banks. The managers of Polar Capital Global Financials (PCFT ) seem reasonably sanguine about the prospects for that trust’s portfolio.

PCFT has given back some of its outperformance of its MSCI All Countries World Financial index benchmark recently, but over the longer term has still done a good job. Three years ago in April 2020, in the throes of the Covid-related panic that had overwhelmed markets, PCFT ran a serious risk of disappearing.

That market upset happened to coincide with a 100% tender opportunity provided around the seventh anniversary of its launch. As at end May 2023, the investors that hung on and agreed to back the trust to continue have since been rewarded with a 59.3% total underlying investment return, whereas an ETF matching the benchmark index would have returned 53.1%.

Banks have made share price gains since 2020 on the back of higher interest rates. There are few sectors that welcome higher rates, but it is much easier for banks to make a larger margin between the cost of deposits and the income from loans/investments when rates are higher.

However, it is not all one way. Higher interest rates also increase the risk of defaults as borrowers struggle to service floating rate debt and fret about how they are going to be able to refinance fixed rate debt.

The return of inflation and rising rates has also exposed some poor risk management. In the space of a couple of months, we saw the collapse of Silicon Valley Bank, Silvergate, Signature Bank, Credit Suisse and First Republic. All of these banks experienced significant and rapid withdrawals of customer deposits before they went under. One reason why customers fled the US banks on this list was that they had amongst the highest proportion of deposits that were not covered by state guaranteed deposit insurance. Given that, the slightest hint of a problem almost guaranteed a race for the exit.

Fortunately, while PCFT had some minor (about 0.3% of its portfolio) exposure to Silicon Valley Bank at the start of 2023, this was sold before news emerged of customer withdrawals from that bank. PCFT had no exposure to the other banks in this list.

The fund managers Nick Brind, John Yakas and George Barrow also slashed PCFT’s exposure to small and mid-sized US regional banks. These are often the ones whose loan books are most exposed to the commercial real estate market. However, for most banks any problem here should be manageable.

By contrast, the perceived stability of banks such as JPMorgan Chase, the trust’s largest holding, and Wells Fargo, a top-10 position, has meant they are net beneficiaries from a flight to safety. In the EU, higher standards of regulatory supervision mean that most banks are in better shape than their US counterparts, even to the extent of regulators permitting share buybacks. At the end of May, PCFT had about 16% of its portfolio in Europe.

However, PCFT has more exposure to Asia (18% of the portfolio), including holdings in India’s HDFC, Indonesia’s Bank Central Asia and Hong Kong-based insurer AIA. The attraction of stocks such as these is that they are operating in fast-growing markets, riding the long-term trend of the growth of the middle classes in the region. China’s sluggish economy is not helpful in the short-term, but the trust has no direct exposure to the country’s banks and just 0.7% in Ping An Insurance at the end of February.

Insurance stocks look well placed in many markets and the managers highlight the opportunity in reinsurance where a run of losses has constrained the availability of capital and premiums are on an upward trajectory.

The number two and three slots on the list of PCFT’s largest holdings are occupied by Visa and Mastercard. Payments companies are doing relatively well:  double-digit revenue growth in the first quarter of this year driven in part by growth in less mature markets and the general trend toward electronic payments.

Like so many other trusts, PCFT has seen some widening of its discount this year and its shares trading over 9% below their net asset value. However, the trust has been buying back stock and it seems unlikely the discount will get much wider.

Notwithstanding the relatively upbeat picture that the managers paint of PCFT’s prospects, they are cautious. The sector may be trading at close to record valuation lows relative to wider equity markets, but with investors nervous about recessions, the managers think that there could be opportunities to pick up some real bargains in the months ahead and are keeping their powder dry. It seems unlikely to me that rates will fall as quickly as they rose. While there may be some indigestion to come, the long-term picture for PCFT looks better than it has in a while.

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