Finance & Banking
In the financial sector, bank on the details

A key pillar of Capital Group’s approach to investing is a long-term outlook. Portfolio managers are encouraged to make high-conviction purchases and to hold them for years — a practice sometimes called “coffee can investing.”

The term comes from an earlier time in American life, when workers — especially those with limited access to good banks — would store their money in tins and stash it in a hiding place. A coffee can stock is one that an investor hopes to hold for years or even decades in the belief that the company has the right features to produce sustained, outsize annual returns. It is, in other words, a purchase that is theoretically stowed away based on a manager’s confidence in it.

So it may be ironic that, when it comes to the financial sector, Capital Group Private Client Services portfolio managers have found relatively few banks worth storing in the proverbial coffee can. Instead, our managers generally have gravitated toward other types of companies in the financial sector, such as securities exchanges and insurance brokers.

There are places where banks shine. Capital Group Private Client Services portfolio managers and analysts have found opportunities in regional banks that enjoy local tailwinds, whether from changing demographics or localized growth. And, of course, some banks are simply exceptionally well-run, robust businesses — the kind that have strong vision and adapt to changing tides.

But deep research shows that many other financial institutions have investment appeal, especially considering that many of the banks represented in indices appear to be fully priced. 

Only select stocks go in the coffee can.

So what makes for a coffee can stock, and how does that play out in the financial sector? The characteristics differ for each analyst and portfolio manager, but there are some common traits, according to Jan Inscho, a Capital Group Private Client Services portfolio strategist. 

“We’re trying to achieve prudent long-term capital appreciation with attention to downside risk,” she says. “That means we are drawn to businesses that aren’t unduly affected by variables outside their control, like market cycles and interest rates. Additionally, large parts of the financial industry have become commoditized or disrupted. Therefore, we are particularly keen to identify businesses with strong market positions, pricing power and wide competitive moats. High potential for returns and growth. Disciplined and focused management are essential, as are strong balance sheets and the ability to fund growth through free cash flow.”

Banks must set aside funds during recessions to cover potential lending losses

This chart shows the relationship between bank reserves set aside to cover potentially bad loans and recessionary periods. During recessions in 2001, 2008 and 2020, banks set aside more cash, reducing their ability to invest elsewhere. Reserves rose especially sharply in 2008 and 2020 before tapering off. Bank reserves reflect funds set aside by U.S. commercial large banks for loan and lease losses. Chart is logarithmic. Sources: Refinitiv, Federal Reserve Bank of St. Louis. As of August 2021.
Sources: Refinitiv, Federal Reserve Bank of St. Louis. U.S. commercial large bank allowance for loan and lease losses shown. Shown in logarithmic scale. As of August 2021.

In the financial sector, that’s led to an investment mix that stands in stark contrast to widely followed benchmarks. Although many people conjure images of banks when they think of the financial space, it encompasses a diverse set of industries. They can include exchanges, where securities traders buy and sell stocks, bonds and a wide variety of other financial instruments; insurers; payment processors, which handle debit and credit card transactions; and companies that provide market, economic and credit data and analysis. 

Whereas many equity indices are heavily weighted in favor of banks, Capital Group Private Client Services’ three major equity services have been especially drawn to other financials, such as exchanges and insurance brokers. Though there are short periods when banks may enjoy higher return, over longer periods companies with more sustainable business fundamentals have tended to do well. For example, for the five years ended July 31, the financial stock selection in each of our equity services provided better returns than their benchmarks.

Choppy markets have been associated with higher revenue for exchanges

This chart compares the average daily volume of exchanges to daily volatility. The figures tend to be correlated, with high trading volume often occuring during periods of high volatility. Volatility is represented by the CBOE Volatility index (VIX). Sources: Refinitiv, Securities Industry and Financial Markets Association. As of August 2021.
Sources: Refinitiv, Securities Industry and Financial Markets Association. Volatility represented by CBOE Volatility Index (VIX). As of August 2021.

There are many reasons a bank-light asset mix can be attractive, Inscho says. Commercial banks are inherently affected by interest rates and economic cycles, over which they have little control. This makes them generally less resilient to downturns, when revenue-generating interest rates and demand for loans are likely to be low. That’s compounded by higher default rates, a risk to which banks are particularly exposed given their lending activity. And many of their products aren’t differentiated: One bank’s checking accounts and loans are likely to be highly similar to another’s, which erodes pricing power as companies race to offer the cheapest service.

Opportunities exist in every industry.

Many Capital Group Private Client Services portfolio managers and analysts have favored exchanges, which often have many of the hallmarks of a strong, long-term investment. Exchanges tend to be cash generative and able to maintain strong balance sheets. They’ve tended to consolidate, giving them some monopoly power, and they’ve shown a lot of product innovation. They often have high profitability, typically command strong pricing power and are insulated from the kind of shocks that banks can experience during economic downturns and periods of low interest rates. In fact, exchanges often benefit when volatility is high, as traders buy and sell more.

In Asia and Latin America, our equity portfolio managers have been attracted to companies benefiting from the growing penetration of financial services. A burgeoning middle class with greater disposable income is saving, investing and seeking to create wealth in places such as China and Brazil. Insurance, mobile payment platforms, asset management and financial exchanges are growing rapidly as a result. 

In Europe, regulators recently ended a restriction on dividends that was instituted during the pandemic, notes Matteo Merlo, an equity analyst who covers banks in Western Europe. Select European regional banks enjoy strong markets that are in a position to benefit from the recovery and support dividends.

“The July 30 stress test was better than expected, showing many of these institutions are healthy,” Merlo says. “And with a strong second quarter boosting earnings, select banks are even embracing catch-up dividend payments. Some could yield as much as 11% this year.”

This is a reminder that setting hard-and-fast rules for investing rarely leads to desired outcomes. Putting in the hard work of fundamental research and keeping an eye on the goal — a good outcome for investors — can mean taking a less traveled path.

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Finance & Banking
Fall 2021 Quarterly Insights
Monetary Policy

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