Big U.S. Banks Had A Good Quarter. We Still Have No Plans to Invest in Them.
The collapse of Silicon Valley Bank and Signature Bank in March sent chills down the spine of an already anxious U.S. economy. It seemed very possible that the volatility within the banking sector might be the final factor to push the U.S. into–what seems like–its most-anticipated recession ever. But that recession has still not yet materialized, and U.S. banking behemoths just reported first quarter earnings that beat analyst expectations.
So, is the banking sector strong or troubled? The positive news out of large U.S. banks may quell the market’s concerns of a full-blown banking crisis reminiscent of 2008, but our team at Martin Currie sees plenty of reasons for investors to remain cautious of the sector over the long run. Despite strong earnings from the biggest banks in America, we see significant structural risks facing both large and small banks, and we view the sector as unappealing in terms of long-term investor value creation. Here are a few reasons why.
Why our Global Long-Term Unconstrained team does not invest in banks
There are several reasons why banks do not meet our criteria for sustainable growth, starting with the financials. In our assessment of potential investment opportunities, we look for companies that can generate returns that are superior to their cost of capital on a consistent basis, using a defined cost of capital assumption. If a company cannot generate a positive spread between its returns on invested capital and its cost of capital, it will, by definition, not create value for shareholders. If the spread is negative, the company will actually destroy value for shareholders. For companies in the financial sectors, the measure we use is the return on equity, which we compare to the cost of equity, using a higher threshold. Overall, in the financial sector, we struggle to find companies that will be able to sustainably generate a positive spread between the return on equity that they generate and the cost of equity that we assume.
In addition to a challenging financial picture, banks also face unfavorable industry dynamics. With so many banks operating in each market and a lot of competitive intensity in the sector, competition risks and customer power risks in the industry are high. Last month’s banking turmoil perfectly illustrated this phenomenon, as small banks lost billions of dollars in deposits to their large competitors. In the days after SVB’s collapse, the 25 biggest U.S. banks added $120 billion in deposits to their balance sheets while deposits at smaller banks fell by $108 over the same period.1 This shift in consumer behavior appears to have supported the strong earnings from large U.S. banks.
But even legacy banks are challenged by new entrant and disruption risks from neo-banks, which are fintech firms that are exclusively online and offer apps, software and other technologies for mobile and online banking. Last week, a new competitor entered the market with the launch of a new high-yield savings account that will pay depositors an annual percentage yield of 4.15%, a rate they claim is more than 10 times the national average. In today’s environment, depositors are expecting banks to keep up with the U.S. Federal Reserve’s historic rate-hiking campaign by paying interest on their savings accounts. And neo-banks appear to be ready to capitalize on the willingness of consumers to “vote with their pocketbooks.”
In addition to being able to provide banking services to customers, neo-banks are–in our view–more agile, more innovative and unencumbered by the legacy IT systems of traditional banks. Many traditional and incumbent banks run multiple IT systems due to the lack of proper integration or rationalization from past mergers and acquisitions. Meanwhile, neo-banks are appealing to digital natives and may provide customers with a better user experience with the use of data and artificial intelligence. The disruption of the banking system by neo-banks is already well underway. Data shows that there were 14.4 million neo-bank account users in the US in 2020, and that number is expected to more than double to 39.1 million by 2025.2
Banks are also highly regulated and are constantly at risk of more stringent regulatory requirements. Some of the regulatory requirements center around requiring banks to hold higher levels of capital on their balance sheets to ensure robust capital adequacy and liquidity ratios. These requirements are put into place to protect banks against various operational risks and protect depositors, so we believe that regulators have good reasons to impose these requirements in times of stress. However, these regulatory constraints dilute banks’ returns on equity, adding yet another factor that negatively impacts the banking sector’s return on equity.
High conviction sectors
Martin Currie manages investment portfolios unconstrained by sector, geography or market capitalization, allowing us to focus on our best ideas and highest conviction stocks from anywhere around the world. Our unconstrained portfolios are also highly concentrated, so we carefully choose each stock with a strong emphasis on identifying quality growth companies with sustainable business models. We define “quality growth” as companies with supportive structural growth prospects, high return profiles and solid balance sheets.
Our research is focused on finding undervalued companies operating in industries with high barriers to entry and dominant market positions, strong pricing power, low disruption risk and high structural growth prospects. We also consider how companies will benefit from three mega trends that we believe will be key to capturing growth: demographic changes, future of technology and resource scarcity.
With these factors in mind, we have a significant allocation to companies within the information technology sector. We are particularly interested in capturing growth opportunities within the semiconductor industry, which we believe will be accelerated by the global low-carbon energy transition and the growing technological connectedness of our world.
Our portfolios also have a healthy exposure to consumer discretionaries, despite lingering inflation and its impact on consumers over the short term. We believe that consumer discretionaries, such as luxury goods, will benefit from long-term demographic changes, like growing spending power from millennials and Gen Z, as well as the growth of the middle class in emerging markets, particularly in Asia.
With our unconstrained approach to investing, we are not concerned about having zero exposure to some sectors, like banks, where we do not see opportunities for sustained value creation over the long term. Rather, we prefer to put our investors’ capital to work in businesses that operate in industries with favorable dynamics for value creation, and that we believe will generate better returns with lower risk. Despite a good earnings season for big American banks, we have no plans to invest in them due to our view that they are facing unattractive long-term fundamentals.
Zehrid Osmani is lead portfolio manager for Martin Currie’s long-term unconstrained strategies. Martin Currie is a global active equity specialist with $20.8 billion in assets under management as of December 31, 2022, and is a specialist investment manager of Franklin Templeton.
2. Source: Insider Intelligence. https://www.insiderintelligence.com/chart/247459/us-neobank-account-holders-2020-2025-millions-change-of-population/
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