Banks were the largest contributor to a surge in UK dividend payments in the second quarter, after the Prudential Regulation Authority allowed them to restart payouts.
But a return to income production is not enough to guarantee a good investment case.
At the height of last year’s economic uncertainty and market volatility, the Bank of England’s Prudential Regulation Authority (PRA) restricted banks from making dividend payouts to ensure sufficient capital was held to weather potential losses.
In July, the PRA announced the immediate removal of these restrictions on full-year 2020 dividend payments for the sector – choosing a slightly different tack to the European Central Bank, which opted to maintain curbs until September 2021.
The latest Janus Henderson Dividend Index showed UK banks have lost no time in embracing their newfound freedom, contributing significantly to second quarter payouts, which jumped 61% year-on-year. HSBC was one of the largest contributors, with Barclays, Lloyds (owner of Halifax Bank of Scotland) and NatWest (owner of Royal Bank of Scotland) all reinstating dividends too.
It’s undoubtedly good news the banks are back to paying dividends, as it shows confidence in the economic recovery from the Bank of England. It also demonstrates the strength of banks’ balance sheets in comparison to the aftermath of the Global Financial Crisis back in 2007-2009, which should bode well for the financing of businesses and individuals over the coming few years.
But we believe there are other ways to play the relative strength in financials. Besides Barclays, which we believe is underappreciated given its proven investment banking capacity and more international focus, we own no UK high street banks.
While we do not avoid financials as a sector, we tend to look for companies that have a more diversified asset base and more pricing power than the high street banks.
Here are five financials we do own:
1. Close Brothers
We have held this on and off in the Church House UK Equity Fund since inception.
The Fund recently had its 21st birthday, and Close Brothers was held in the portfolio on day one. We like it because it is an old school merchant bank with slightly different DNA. The core banking part is not high street but private financing to small regional businesses: supporting the nuts and bolts of the UK economy.
The company has historically been run very conservatively, which we like as it has proven through multiple cycles that rather than just grow the loan book it will do so only when pricing is right and the returns on offer are decent relevant to the risk it is taking on. Finally, it owns broker Winterflood, which has done brilliantly in the volatile markets over the past 18 months.
2. London Stock Exchange Group (LSEG)
We like businesses involved in the asset management sector. Schroders, for example, we owned for almost two decades, and it was a top 10 position more or less throughout that time. On top of asset managers themselves, there are those who provide ancillary services such as LSEG. We added it to our portfolio last year when it had sold off on Brexit and acquisition worries. Its barriers to entry are very high, since it has c.99% market share in some of its exchange and clearing house businesses. It is not simply a stock exchange business, and the market seems to forget this periodically. The recent acquisition of Refinitiv further diversifies LSEG and so far the integration is on time and ahead of budget – we believe shares are positioned to re-rate higher as the integration risk reduces over the next few quarters.
3&4. Hargreaves Lansdown & IntegraFin
Platform businesses are another service area of the asset management industry that are both capital light and cash negative. Hargreaves Lansdown is probably the best known in the retail investor space and has benefited handsomely from an increased interest in self-directed investment. HL benefited from record inflows during 2020 and is well-placed to build on this success, by encouraging these new users to use the HL platform for their long-term savings and pensions. Meanwhile, IntegraFin, which owns Transact, is used by more than 6,000 financial advisers directing over £41 billion in client funds. It is a ‘pure-play’ platform business offering best in class client service to its UK adviser customers. Customer loyalty is high and revenue excellent.
We have held Barclays for a while now on the basis that it is fairly unique among the high street banks due to its capital markets business. This proved to be beneficial last year when it provided a counter-cyclical ballast while the consumer part of the business was threatened.
The Price to Book (PTB) of Barclays versus comparable US banks is another reason we think it is attractive. It currently sits on around 0.54xPTB compared with JPMorgan’s 1.83xPTB. They are not exactly comparable businesses, but this is a large discrepancy in our view. We added to our Barclays holding in March and June of last year when financials were out of favour and subsequently benefited from the value rally. We trimmed at the end of last year.
Bank on it?
If interest rates do tick up, all banks will have potential upside. For this reason, it is good to have one or two banks in your portfolio if you think inflation could stick around longer than the current “transitory” effect being discussed by central banks.
Bond market yields peaked at the start of the year and have been going down despite short-term inflation trending up. The US 10-year is at around 135bps, the UK 10-year gilt at 61bps and Germany 10-year bund is resolutely negative. With central banks still the dominant buyer in fixed interest markets there is little genuine price discovery and endless economists have been confounded by the fact that bond yields are no longer tracking traditional inflation metrics.
Against the index we are underweight banks, but we have a lot of other financials which leads us to have the same headline level in financials as the index. Typically, we look to invest in businesses with some unique features that stand them apart from their competition. In comparison, the high street banks experience intense pricing pressure, as there is little to differentiate them from one another.