The big bank bet that’s paying off

Over the last few years, The City of London Investment Trust’s (CTY) investment in banks has undergone a transformation. Having been underweight banks since the financial crisis, CTY’s managers have now maintained a consistent overweight to the sector for over 18 months.

Here, we tell the story of that perspective shift.

The booming case for banks

As ever, it begins with analysis. A number of factors emerged from the analyst and management team watching the banking environment.

The first is the interest rate cycle. Higher interest rates lead to naturally improved margins for banks, being the difference between what the interest rates they pay depositors and charge lenders. While this piqued the team’s initial interest, it wouldn’t be enough on its own to drive a purchase.

Next, deeper analyst work uncovered a quirk of timing that added to the sector’s attractiveness.

Banks hedge out over five to seven years the balances they hold from current and deposit accounts. As hedges that had been taken out when interest rates were low expired, new hedges can be taken out at much better interest rates improving banks’ profitability. CTY’s managers felt that this unusual circumstance was underappreciated by the market, as shown in banks’ low share price valuations.

In addition, it has become clear to regulators that banks had sufficient capital and the mood from politicians had shifted towards wanting banks to lend more to stimulate growth. Finally, the banking sector has seen a reduction in competition with Barclays buying Tesco’s retail banking operations and NatWest buying Sainsburys’.  This leaves greater market share for the dominant high street banks to pursue, even as younger tech-led rivals gain some ground.

Timing is everything

All three of these factors meant that the stars were aligned for banks. However, the investment case was compounded by the banks’ dividend culture. With revenue growth on the horizon, many of them guided raising dividends – a trend that has continued.

The City of London Investment Trust aims to provide long-term growth in income and capital. The trust has a 59-year record of increasing dividends. As such, the prospect of dividend growth is a particularly appealing investment return for the trust’s managers.

Buying up banks

Of course, not all banks are made equal. The trust is overweight Lloyds and Natwest, based on the margins that they generate and their particular prospects.

Meanwhile, the managers have taken some profits from Barclays, as the market has demonstrated some concern regarding its investment banking operations. The trust is also underweight HSBC as it is exposed to some political risk, although it has been making progress on pulling out of low return areas and focusing on its profitable channels.

It is also worth noting that in any recession the banks would suffer considerably. The likelihood of a recession therefore forms some of the investment case.

All performance, cumulative growth and annual growth data is sourced from Morningstar.

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