Sector Spotlight: New Rules Could Bring New Opportunities

17th Jan '23 by Roland Head

10 comments 1944 reads

Where are the cheapest stocks in the market today? For investors seeking dividends and value, I think it’s impossible to ignore the UK market’s large financial sector.

A quick look at Stockopedia’s sector listings tells us that in aggregate, the UK’s listed financial businesses are currently trading on what appears to be a value rating:

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Indeed, the financial sector is currently the only part of the UK market that’s trading below its book value. The average yield of 5% is also the highest in the market, bar the Energy sector (which I plan to revisit in the coming weeks).

Arguably, book value isn’t as relevant to modern businesses as it once was. In an age where intellectual property and other intangibles often dwarf a company’s physical assets, book value isn’t always a reliable indicator of valuation.

Even so, when I see stocks trading below their book value, I often find it worthwhile to take a closer look.

A sector of many parts

According to Stockopedia, the UK’s financial sector contains 691 listed securities – nearly 40% of all the securities listed on the London market. For our purposes here, we can quickly exclude many of these. For example: preference shares, overseas stocks, and equity investment trusts.

To further narrow my focus, I’m only going to consider three industry groups within the financial sector:

Industry group	Latest P/B	TTM P/E	TTM div. yield	Median EPS growth forecast
Banking services	0.8	6.5	3.8%	9.4%
Insurance	1.2	12.2	5.9%	23.1%
Residential & Commercial REITS	0.7	7.2	4.5%	-38.1%

These valuation metrics look pretty undemanding to me, especially given the positive outlook for earnings growth at banks and insurers.

However, it’s worth remembering that averages can mask a wide range of underlying values. Clearly, we need to have some understanding of the factors that are likely to influence profitability and valuations in these sectors.

Why I’m interested

There’s no way we can consider this sector of the market without mentioning interest rates.

Last year’s rapid series of rate rises (the UK Bank Rate went from 0.1% to 3.5%) were triggered by surging inflation. But some degree of normalisation was due anyway, in order to help unwind 13 years of central…

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Epitychia

17th Jan '23

Banks are still earning a very low return on capital. I guess they are cheap for a reason.

Norfolk'n'Good

Historically, and I mean 30/40 years plus, they have always earned very low ROC - its the nature of the beast....

Rusty2

Roland, what about Legal & General (LON:LGEN) that has a SR of 84? For some reason missed from your list. B.P. Marsh & Partners (LON:BPM) probably should be under insurance as well.
Quite a few insurers have already seen considerable share price rises in the last few months. Some are paying decent dividends, such as Phoenix group (LON:PHNX).

sady

Investment ,is a tough one so many variables ,constantly changing.If you put a finger on one the other variable moves and destroys everything.Interest rates are up you would think the profit margin should be higher.The more you know the more careful you become.

ACounsell

Your optimism and that of the Bank of England on future levels of inflation is not shared by the likes of Ruffer who see inflation as 'higher for longer', even over the next 10 years. There seem to be some very divergent views from a whole host of commentators on the likely outturn for inflation over the medium term.

Roland Head

Hi Rusty2,

Personally I'm a big fan of both Legal & General (LON:LGEN) (I hold) and Phoenix group (LON:PHNX) (no position). L&G didn't get a mention because it's listed in the Investment Banking & Investment Services industry group rather than under insurance.

Sector classifications can sometimes be a bit of a blunt instrument - in L&G's case, clearly it operates across both insurance and asset management.

Regards,

Roland

Hi Epitychia,

I tend to focus on return on equity as a measure of profitability for banks and insurers. ROE reflects the profits earned on the difference between lending (assets) and deposits (liabilities) - a bank's equity.

Return on capital employed includes all the assets (loans) but excludes most of the liabilities (deposits), so I don't think it provides a meaningful view on profitability for banks.

Of course, banks have also earned very low returns on equity since 2008. This has been due to low interest rates, as well as problems like legal settlements (PPI etc).

Profitability now seems to be improving at UK high street banks, although of course we don't yet know whether this improvement will continue.

However, based on the scenario I've outlined, I think we could see bank ROEs continue to improve (moderately). That could lead to attractive shareholder returns, assuming economic headwinds don't offset the benefit of higher rates.

Hi ACounsell,

I agree, there's definitely a wide range of forecasts out there. What will actually happen is anyone's guess. We can only invest based on known facts and our interpretation of them.

DYOR is always essential -- I'm certainly not predicting any specific outcome.

As Yogi Berra said, "It's tough to make predictions, especially about the future"!

Tommy H

18th Jan '23

Dear Roland

Thank you for the article, as you always manage this is insightful and well written.

Whilst not bullish I am at least positive about a number of stocks within the banking, insurance and REIT sectors.

Partly as one of the funds I am responsible for is well and truly in income mode (Mum's Pension held in ISA - she is 80 years young after all), this has been up and down and in and out this last year (my limited capabilities) but over the last month I have been rebuilding after agreeing the updated strategy and plan. So there are risks within these sectors, as you note the impacts of the cancellation of the final dividend for Direct Line Insurance (LON:DLG) had a read across to Aviva (LON:AV.) and Legal & General (LON:LGEN) and how competitive is the banking sector overall to what is achieved for shareholders versus the race for new/more customers.

I think there are two parts here, which as an individual my holdings are of a size that in all but the worst day I can sell and cut losses (lesson learnt from Covid), so I can buy in and sell out on any given day, should something change. So profit warning = sell for me personally. But at the same time I am not 100% invested so I am using retractions to increase the holding size where I believe it is just that an opportunity rather than a change. I am also spread over a wider number of holdings now (plan 50-60 for mum), so the maximum holding size is 5% whereas it was previously 10%, this is partly a sleep at night factor, but also means that the impact of a profit warning for one company, change in sentiment, Mx Market sell off is lower on the overall capital position. I am also looking at the overall holdings within a sector to ensure that whilst different companies there is not too much within one pot, so if there is a new run on banks for example, again it is reasonably contained.

There is also the emotional part within this and acknowledging that, so whilst I hold Natwest (LON:NWG) and I am very grateful and happy for the recent rise, I also am nervous so I am prepared to take profit and sit on the sidelines for a few days, weeks or months which I did selling Secure Trust Bank (LON:STB) following the rise. Yes I may miss out on a further rise, but I am trying to learn to be ok with that.

Ok time for another Teams call.

Thank you and keep up the good work!

Cheers

Tommy (and family)

ps. I hold Aviva (LON:AV.) Legal & General (LON:LGEN) Natwest (LON:NWG) Lloyds Banking (LON:LLOY) Phoenix group (LON:PHNX)

aflash

22nd Jan '23

Sometime ago,

somewhere else,

in a series discussing investor bias a possible conclusion was that humans were not wired for investor success. A contrarian contributor supported his tale of riches with the anecdote that a wise sage had told him young to invest in financials whatever the macro scenario and he had followed the advice. I did too. I worked in the field which gave me confidence but in fact insiders do not have all the facts nor the macro view necessary to judge ups and downs. Furthermore the permanent parts of my portfolio of banks, insurance and real estate companies do not show a spectacular increase over 30 years or so. It is recognizing when to increase or reduce holdings that makes the difference, hence the importance of Roland's article.

I would argue that it is too late for quick profits in the banking sector which is now overbought. Look at any chart. Long term they are down from all time highs before 2009 but since October 2022 the slope UP is steep.

Stockopedia distanced itself from bank analysis early one, realizing that it does not have suitable algos.

Not so insurance and I remember an exchange about the Combined Ratio where Stocko expressed ignorance of the measure.

So here is how to interpret it:

Combined Ratio - analysis of premiums versus claims

(Claim-related Losses + Expenses) / Earned Premium)

A measure of insurance underwriting profitability where if the ratio is more than 100% then the underwriting is unprofitable.

Sometimes it is mentioned when trading updates are discussed in investment media.

Trade journals would help but they are prohibitively expensive and need either a corporate subscription or a higher net worth than most of us here.

So if nobody in the crowd knows how to judge insurance companies, surely that opens the field to the daring ?

Not so because the crowd is buying and selling and will force the price up or down according to sentiment towards the sector.

Stocko's pessimism led me to another data base which gives different and confusing results. I also invested in the North American insurance market with a much larger number of unfamiliar names.

On the whole, by following the mantra noted above, results have been good because I always am invested somewhere in the sector. In fact it is many sectors among which I would point to property and casualty, reinsurance and life which react differently to events. The general principle is that premiums paid up front create a free investment pool to play with. Property and Casualty has to deal with huge claims from natural disasters but an efficient company will have re-insured the risk. Re-insurance companies depend on the skill of their underwriters. Life has more to do with demographics and selling into growing markets such as Asia.

Interest rate changes affect the return of reserves Insurers have to keep to meet their liabilities. Not so obvious as banks and real estate because of the model.

In all cases nimble operators will deal with the macro environment as it develops but there is no question that public perceptions will determine our profits and losses in this area.

Sector spotlight: new rules could bring new opportunities

A sector of many parts

Why I’m interested

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Roland Head

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