Generalist investors who tried to call the turn in bank shares on the basis that low price/earnings ratios represented ‘good value’ now find themselves sitting on nasty losses. To a non-specialist, big US banks like Citigroup may have looked cheap last September, following the implementation of the first troubled asset relief plan (TARP). But to the small group of financial-sector specialists who understood the forces at work, it was clear that this ‘value’ was little more than an illusion. Throughout the current crisis, the use of superficial valuation metrics has consistently been a dangerous input into stockpicking.
That lack of understanding poses risks to the global economy. It also promotes massive volatility across asset markets in the financial sector and beyond. More importantly, however, it presents some outstanding opportunities to the small group of specialists who really understand financial stocks. Those able to focus on what really drives share prices across the hugely diverse financials universe can derive profits even in what is, perhaps, the most extreme market environment for financials we have ever seen. That’s why we run a global financials long/short fund for Martin Currie.
Diversity of opportunity
The financials space is a large, liquid sector with a huge range of companies. Financial stocks account for around 20% of the MSCI ACWI index. Each financial sub-sector offers exciting opportunities to make money, both long and short. This diversity means that specialist sector knowledge and stockpicking skills are vital to generating returns.
The vast majority of financial stocks tend to be cyclical companies. But the cycles that move profits and share prices across the sub-sectors of the financials universe do not move in a synchronised manner – the cycles that drive, say, reinsurance and investment banking, play out at different times and at differing speeds. At any one time, that creates dozens of potential investment opportunities on both the long side and the short side.
The debt-equity cycle
Whatever financial subsector we are looking at, one common factor always emerges: the vital motive engine of the debt-equity cycle. Understanding that cycle is a powerful predictive tool. And, historically, the debt-equity cycle is inescapable. Indeed, it is at precisely those points where it is claimed that the cycle has been abolished – “no more boom and bust” – that its latent destructive power is at its greatest. Each one of these cycles differs, but we might generalise by saying that debt-equity cycles tend to last for between 15 and 20 years. And, for investors who hope to make money in the financials universe, understanding that cycle is of paramount importance (see Fig.1).
The current deterioration of credit quality is not a blip – it is a long-duration, multi-year event. It is a key part of Martin Currie’s investment philosophy that investors underestimate the likely extent and duration of both positive and negative change. That underestimation and a corresponding belief that share prices will mean revert in the short-term, is why so many non-specialist investors got their fingers burnt trying to call the turn in financials last year. When credit conditions deteriorate, what might seem like ‘value’ can vanish overnight. Conscious of that danger we try to remain ahead of the market in assessing how quickly that cycle can turn. Too many investors underestimate the rapidity with which expansion can give way to contraction and fail to grasp how rapidly credit conditions can deteriorate. What non-specialists also struggle to grasp is the extent to which there can be contagion between apparently unrelated sectors and asset classes. It may seem surprising that what began as a problem confined to the US sub-prime housing market has spread so quickly and so far. But it is our belief that every credit asset class will eventually be significantly impacted by the credit crisis and by the global slowdown.
Understanding the web of connections that links what are, on first view, unrelated companies allows specialists running financials long/short funds to generate alpha. For example, in the early weeks of the current crisis, our understanding of the ecology of the financials universe allowed us to make money shorting US mortgage stocks. But because we were well aware of the extent to which Northern Rock and some other UK lenders had built their growth on faltering wholesale lending markets – and because we understood the changes sweeping those markets – we rapidly turned our attention to UK mortgage stocks. In that way, we generated alpha. European and Asian banks may be next in line: even now, we believe the market doesn’t fully appreciate how rapidly they will capitulate and how far they have to fall. In particular, we believe the market still hasn’t understood how severe the coming deterioration in credit conditions will be in Australia.
So, before they examine the broad subsectors – commercial banks, investment banks, life insurers and non-life insurers – that comprise the financials universe, would-be long/short investors need to understand the debt-equity cycle. But generating alpha from understanding the debt-equity cycle is not just a matter of making top-down judgements. Instead, it demands painstaking bottom-up work on a company level. If that analysis is performed correctly it not only reveals opportunities on an individual stock level, it should also throw light on the debt-equity cycle itself, feeding back into a greater understanding of the complex ecology of the financials universe.
Sub-sectors: 1. Commercial Banks
Commercial banks constitute the largest and most diverse subsector of the financials sector. Because they create credit, understanding the banks is fundamental to understanding the debt-equity cycle. Equally, understanding the debt-equity cycle is fundamental to generating returns in this part of the market.
At this stage in the debt-equity cycle, the level of negative change and credit deterioration is such that governments and regulators are panicking about the solvency of domestic banks. In response, they are imposing stress-test scenarios on the banks to see how their capital ratios may evolve over time. Those whose core tier-1 capital ratio falls below a given threshold (4% in the UK) under the given scenario are obliged to rebuild their balance sheets by raising new capital. In the UK, of course, the additional capital required to meet the government’s stress test pushed banks such as RBS and HBOS into undertaking rights issues, which the market, quite understandably, shunned. Partial nationalisation resulted, with grim implications for equity holders.
As such, understanding capital ratios is fundamental to generating returns in the commercial banks sector. We therefore perform our own ‘stress tests’ to determine banks’ likely capital strength in a number of given scenarios. The accuracy of those tests determines our ability to identify which banks will need to issue further equity.
Performing these stress tests is a dynamic process. As the economic cycle turns, fresh pressure is being applied to capital adequacy ratios by asset writedowns and by steadily mounting losses on non-performing loans. These tests, of course, cannot be performed in isolation. We must also factor in potential changes in the way governments, regulators and markets view capital ratios. After more than a year of unprecedented dislocation, the market is scrutinising banks’ balance sheets to an unprecedented degree and following the most conservative accounting practices. Understandably, after the sharp losses suffered recently, the market wants to know what the buffer is to protect shareholders from losses arising in banks’ loan books.
Performing these tests is a complex, labour-intensive task for which non-specialists are ill suited. But by focusing on capital adequacy ratios, we can anticipate which banks will require further capital, and which will not. That done, our task is simple: we go long of banks that won’t require capital, and go short of those that will.
For example, a recent pair trade from which we profited was to be long of JP Morgan Chase and short of Bank of America. On the surface, both banks seem ‘too big to fail’. And, indeed, they are. A generalist, however, might believe that both therefore represent long-term survivors. An analysis of their capital positions, however, shows that while Bank of America may be too big to fail, its existing shareholders might not participate in much of its future success.
Late last year, our modelling showed that Bank of America would be forced to raise capital – a lot of capital. In contrast, our modelling showed that JPMorgan Chase’s balance sheet looked solid. We were right: in January, Bank of America went cap in hand to the Fed for $20 billion while JP Morgan Chase has outperformed. Only sector specialists, we believe, can exploit this type of dispersion. Therefore, even in the most financially stressed part of the market, we can find opportunities to take profitable long (and short) positions.
Sub-sectors: 2. Investment Banks
In the middle of a financial crisis, it might intuitively appear reckless to get involved in the high-beta investment-banking sector. But this is precisely where we believe the benefit of evidence-based investing comes into its own. Investment banks were central to the credit crisis we saw last year. Some of Wall Street’s most august names are no longer with us, or survive merely as nameplates for commercial banks.
But, having wreaked havoc and reshaped an industry, the financial storm has moved on. That storm has left us with a smaller investment-banking sector, but one in which there is an attractively wide dispersion of valuations. That presents specialist investors with opportunities. After taking a battering in late 2007 and 2008, investment banks have started to repair their balance sheets; some already look strong. Morgan Stanley, for example, shrunk its balance sheet dramatically late last year, reducing its leverage from 32 times at the end of 2007 to just 11 times. It has already marked its balance sheet to market and written down or sold off its bad assets. As a result, it has no exposure to mainstream credit. While most stocks in the commercial banking universe will feel losses for years, Morgan Stanley has already faced its demons.
The markdowns Morgan Stanley has applied to troubled assets appear overly conservative. Crucially, it has a tier-1 capital ratio of over 17%, meaning that current shareholders are unlikely to be diluted in the near future. The potential for Morgan Stanley, therefore, to experience positive change is significant. And while, at the time of writing, non-specialists are wary of going long in investment banking stocks, it clearly represents unusually high quality at an unusually low valuation. Finally after a difficult period we can start to put more trust in the book value of Morgan Stanley and turn to the thorny issue of modelling its potential earnings profile.
Equally, there remain opportunities to make money by shorting stocks. Some other investment banks have failed to address their problems with the vigour that Morgan Stanley showed last year. We believe several large investment banks in other parts of the world still have serious issues with their balance sheets, and remain materially expensive, allowing us to make money by shorting them.
Sub-sectors: 3. Life Insurers
More than any other market sector, financial stocks demand to be analysed and understood in a global context: a globalised industry requires a global view. At the time of writing, this is, perhaps, most evident in the life insurance sub-sector. Here, we are applying the lessons learned by life insurers in one market, the US, to their global peers. And, for shareholders in non-US life insurers, the results of that read-across are troubling.
In recent months, it has become clear that US life insurers are highly geared to a number of distressed asset markets. The liabilities of these companies move in a complex way, but the assets in which they invest – asset backed securities, corporate bonds, alternative investments, private equity – have all moved in the same direction: downwards, and sharply.
As a result of this fall in asset values, the book value of non-US life insurers has been eroded. Ratings agencies have started to turn against the sector and downgrades are coming through. Stockmarket valuations for US life insurers have crumbled. The implications for the sector globally are troubling – but we don’t believe that some investors appreciate the extent to which life insurers outside the US are leveraged to markets.
Too many generalist investors rely on embedded values (EV) to value life companies. This may be the metric traditionally used to value the sector, but we don’t believe that focusing on EV is helpful in the current conditions. Instead, we prefer to apply the harshest quality metrics we can find. This gives us a realistic view of the rapidity with which book values are declining.
Over the last 12 months we have fixated on asset leverage across the financials universe. Asset leverage ratios may be a blunt tool, but given the extent to which European life insurers are exposed to asset markets, it is entirely possible that some may continue to have ‘embedded value’ but absolutely no tangible shareholder equity. And because we are potential shareholders, that’s what matters to us.
Negative change comes in waves. European banking stocks have already crumbled, but investors are about to realise the extent to which some of the continent’s life companies are leveraged to distressed asset markets. When they do, we aim to profit.
Subsectors – 4. Non-life insurance
That the financials universe is a diverse environment in which there is always the opportunity to make money no matter how extreme the market environment is best illustrated by the non-life insurance sector. A year ago, we were attracted to non-life insurers by their solid balance sheets and low levels of asset leverage. These contrasted sharply with the rest of the financials universe and provided us with profitable opportunities to go long even as credit markets deteriorated.
At the start of this year, many investors, wedded to the concept of mean reversion, took the view that having performed well last year, it was time to take profits in non-life insurers and look for long positions amid ‘riskier’ financial stocks. We couldn’t disagree more. If we can’t see evidence of quality, we won’t buy a stock. Furthermore, while being long in life insurers was an attractive defensive option a year ago, things have moved on. What was once a defensive shelter is now experiencing positive change. The world looks a riskier place than it did a year ago and a fall in the capacity of the insurance industry has driven insurance rates higher. As a result, non-life insurance has gone from a sector in which to hide, to one delivering positive change. At this stage this is most obvious in reinsurance segments; we are long stocks with exposure to these segments. Despite the financial crisis, that positive change is what we – and the Martin Currie Global Financials ARF – invest in.
ABOUT THE AUTHORS
Len Riddell has spent his entire career as a financials specialist. He began his career in 1996 in the banking division of PriceWaterhouseCoopers in London. Prior to joining Martin Currie, he analysed European banks for Merrill Lynch’s highly rated team and analysed Irish financials for Goodbody Stockbrokers in Dublin. Riddell joined Martin Currie in 2004. He researches and recommends global commercial banks and is the co-manager of Martin Currie’s Global Financials Absolute Return Fund.
Paul Sloane is a financials specialist. He began his career in 1993 as a trainee chartered accountant at Standard Life. In 1997 he joined Standard Life Investments as an investment analyst. Following brief stints with Royal Bank of Scotland and National Australia Bank, he joined Deutsche Bank’s top-rated insurance research team in 2001, where he was responsible for specialist sales in the pan-European insurance sector. Sloane joined Martin Currie in 2003. He researches and recommends global insurance and diversified financials stocks and is the co-manager of Martin Currie’s Global Financials Absolute Return Fund.