Sector spotlight: new rules could bring new opportunities

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:

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:

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 bank easing.

Source: Bank of England

Rates are still fairly low by historical standards, but they’re higher than they’ve been for a long time. For a whole generation of investors – including many professionals – the rules of the game have changed.

All else being equal, higher borrowing costs should make it possible to earn improved income returns from relatively safe assets. For the big banks, this could support a return to double-digit returns on equity – something we’ve not really seen since the financial crisis.

Right now, high inflation means that real (inflation-adjusted) returns may still be negative. However, it’s worth remembering that historically, this wasn’t the norm.

This chart from Schroders shows that for much of the last 70 years, the UK Bank Rate (green line) has been higher than CPI inflation (blue line). During these periods, investors should theoretically have been able to generate positive real returns from risk-free assets such as government bonds:

Source: Schroders

The Bank of England’s latest Monetary Policy report suggests to me that these conditions could soon be seen again.

The report suggests that inflation could fall to a mid-single digit level by the end of this year, before dropping to 2% by the end of next year. This is paired with a fairly bearish view on unemployment and GDP growth by the Bank.

External forecasters are slightly more optimistic, but the overall implication is the same – serious inflation is not expected to persist much beyond this year:

Source: Bank of England Monetary Policy Report Nov 22

In contrast, interest rates are expected to stabilise close to their current levels. This raises the possibility that by the end of next year, investors might be able to generate positive real returns from risk-free assets. That’s not been true for a long time.

Source: Bank of England Monetary Policy Report Nov 22

Of course, economists are said to have correctly predicted nine of the last five recessions… We can’t be sure what will happen (or when), so I’ll consider some of the risks below.

However, if these forecasts are broadly correct, the implication – as Oaktree Capital founder Howard Marks recently argued in the FT (paywall) – is that “lenders and bargain hunters face much better prospects” than they did between 2009 and 2021.

Strengths & opportunities

I expect the impact of higher funding costs to ripple across the whole market, over time. In my view, some of the early beneficiaries may be financials – most obviously banks, and then perhaps insurers.

I think Property REITs may also offer opportunities, albeit for slightly different reasons.

Banks: Higher interest rates are allowing UK banks to rebuild their net interest margins (NIM) by increasing lending rates more quickly than rates on deposits. This increases a bank’s net interest income.

There isn’t a hard-and-fast link between NIM and interest rates, as this piece from accountants Deloitte explains. But for now at least, that seems to be the direction of travel:

Insurers: Insurance firms are big investors in government debt and property. Over the last year, revaluation losses and claims inflation (for non-life insurers) have put some pressure on profits and surplus capital coverage. Last week’s profit warning from Direct Line Insurance (LON:DLG) suggests this process may still be playing out.

However, on a medium-term view, higher interest rates should theoretically allow insurers to increase their investment returns from high-quality assets. Assuming inflation eases, I expect the insurance sector to benefit from higher rates.

Interestingly, the StockRanks don’t yet share my optimism. The Insurance industry group has an average StockRank of just 53.

Only six UK-listed firms have StockRanks of 70 or more. Perhaps it’s a little too soon?

Commercial property REITs: Property investors must balance property prices, borrowing costs, and rental rates in order to make a profit.

If one of these factors changes suddenly, then there has to be a corresponding change elsewhere. So far, prices have fallen and transaction volumes have slumped, as potential buyers wait to see how the market will settle.

In my view the main opportunities will be buying the best quality property at reasonable discounts – or finding special situations at deep discounts. I’ll explain why below.

Risks

As an investor, my main worry is that the combination of high inflation and higher interest rates will lead to a much deeper recession than the market is pricing in.

If this happened, then banks would likely suffer a sharp increase in bad debt levels and new lending would likely slow. This would probably offset any benefit from higher interest income. Last year’s rate rises might also be reversed.

A more nuanced scenario might be that banks find that they have to pass on more interest to savers, while keeping their mortgage rates competitive. That could limit much further expansion of net interest margins.

Banks and insurers seem to have fairly healthy balance sheets, so I don’t expect a repeat of the near-death experiences seen in 2009.

In the property sector, landlords could face pressure from near-term refinancing costs. However, most seem to have anticipated rising rates and be reasonably well positioned. I think a more interesting factor for commercial property (mainly offices) may be the impact of new rules on environmental rating.

From April 2023, office buildings will have to meet a minimum EPC rating of E in order to be let. From April 2030, this requirement will be increased to an EPC rating of B.

Tenants signing 10-year leases today need to know their offices will still be compliant in 2033. My guess is that some non-compliant property will be upgraded relatively easily, while some will be prohibitively expensive to improve.

Identifying REITs with property that can be uprated cost effectively might present an opportunity for investors.

More prudently, I think it may make sense to focus on the top end of the commercial property market. Demand has remained robust so far, but valuations currently look relatively reasonable to me.

Conclusions

I’m quite bullish about the value on offer in financials. Both my own portfolio and the SIF folio are quite heavily weighted towards this sector.

In my article next week, I’ll take an in-depth look at one financial stock to explain in more detail why I’m interested.

In the meantime, I’d welcome your thoughts below on the current appeal (or otherwise!) of this important sector.

Disclosure: At the time of publication, Roland owned shares of NatWest Group and Direct Line Insurance.