How has the fund coped with the recent volatility in the
The fund has kept pace with its benchmark. Given the attractive
valuations that are found in the financial sector, we're looking to
assume a small measure of risk in the portfolio. On average, every
dollar that one invests in the broad market provides $1.44 in
intrinsic value. But in the financial sector, a one-dollar
investment provides about $1.53 in value. By our measurements, this
is the greatest value found in any market sector.
This value is a direct result of the fear that has gripped the
market. Recent downgrades to economic growth forecasts and the
European sovereign debt crisis have created these high valuations
for financial names. There's been an increased perception of risk
in the financial sector compared to other sectors since 2009. When
a financial crisis exacerbates a recessionary environment,
investors associate financial distress with recessionary fears.
That's the environment we face today and consequently many
investors have avoided financial names. We believe that the sector
will perform strongly in the future and that investors should begin
to add risk to their portfolios.
Why is this a good time to invest in financials?
Our valuation model has a forward-looking component that
accounts for long-term growth rates. We measure whether the market
has reacted appropriately to negative news and believe the market
has overreacted significantly to the downturn. The last time we saw
this much value in the market overall was March 2009, when we
calculated a value-to-price ratio of $1.42 for every dollar
invested. We find ourselves in a similar situation today. From
March 9, 2009, to April 9, 2009, the S&P 1500 Financial Index
gained just more than 66 percent. But the financial sector hasn't
been popular for a long time.
When I joined ICON in 2000, the technology bubble was in place
and no one wanted to talk about the base materials fund that I
managed at the time. During the last six years, base materials have
become a popular topic. We're in that same situation now with
financials. The sector has become a political target and few
investors want to speak about financials. But the sector can
receive a boost from any small vote of confidence. Recently,
Meredith Whitney said that
Bank of America
) wouldn't need to raise additional capital. Afterward, the
lender's shares gained 10 percent. Ironically, the next day Warren
Buffet invested $5 billion in Bank of America. The lender's shares
initially rose 18 percent the day before Federal Reserve Chairman
Ben Bernanke revealed his outlook for the US economy at Jackson
Hole, Wyo. It's remarkable how strongly financial shares react to
just a bit of good news.
What financial subsectors do you believe are the most
Diversified financials have taken the brunt of the downturn.
There's significant value in this subsector. We've been underweight
the group this year, but have started bringing our exposure up to
the same level as the benchmark. Life and health insurance,
investment banking and brokerages and diversified banks are the
subsectors that provide the most value.
We're underweight real estate investment trusts (REIT). When the
yields in the marketplace are as low as they are now, many
investors become excited about REITs and the dividends they
provide. However we feel that the enthusiasm has been overdone.
Consumer finance has been one of the leading industries in the
space and we've had a significant weighting to this subsector since
the first half of the year, including names such as
), a publicly traded pawn shop chain. Those investments have helped
our fund keep up with the benchmark, but the valuations have
changed. Consequently, we've reduced our exposure to the sector and
spread it among diversified financial services and investment
banking and brokerage operations.
How are the banks and insurance companies coping with
this low interest rate environment?
The banks make their money off the steepness of the yield curve.
If they can borrow money for almost nothing and then loan it out
for something, profit margins shouldn't be badly hurt by low
interest rates. Most of the downward pressure on financial
institutions is based on the value of their assets, not profit
margins. Earnings flattened the first half of this year but
analysts still predict they'll rebound.
Analysts still predict reasonably strong earnings-per-share
(EPS) growth for the industry. Analysts expect that by
third-quarter of the year, the 12-month trailing EPS will have
risen 23 percent. Analysts see the environment as favorable, but
the market must clear the mental hurdle posed by the struggling
Recently Bank of America donated a number of houses in depressed
markets to local governments. These properties will be razed and
turned into playgrounds. The carrying costs of the homes were
higher than the value of the homes themselves, so the tax write-off
from the donation made sense for Bank of America. But it's
difficult for investors to view this move as a positive sign for
the banking industry.
What risk do mortgages pose to the financial sector given
that loan-loss provisions are being stepped back?
That data will be reflected in forward-looking EPS estimates.
The bottom line is that analysts haven't forecast a negative
forward-looking EPS. The fear over mortgages is more psychological
than an economic reality.
Because forward-looking earnings numbers haven't changed
by much, regulatory changes from Dodd-Frank or Basel III also
don't pose a great risk to the sector?
That's correct. I also believe that the effects of European
sovereign debt crisis will not be as dire as many predict. Remember
that the 1998 Asian Financial Crisis was supposed to lead to a
contagion that would cause the rapid devaluation of a number of
Asian currencies. Many predicted that the Asian Financial Crisis
would have a significant impact on the global economy, but this
never came to pass. From the perspective of valuation, the market's
overreaction to potential risks in the financial sector has created
an excellent entry point for long-term investors.
Can you name some of your favorite plays in the financial
NASDAQ OMX Group
) makes money every time shares of stocks change hands, and
benefits from increased trading volume during volatile periods.
Exchanges such as NASDAQ OMX Group have witnessed an interesting
new investment trend. In 2000, many believed that a retirement
portfolio should have at least a 10 percent allocation to gold.
Commodities such as gold weren't seen as suitable investments for a
retirement portfolio. Since then, an astounding amount of assets
have shifted to commodities and volumes in the stock markets have
reached a plateau.
It's arguable that much of that shift has been a result of a
six-year decline in the US dollar, which has made commodities more
attractive as investments. But what happens when that trend
reverses? We see significant value in exchanges. Five years ago, no
investor wanted to talk to about natural resources. Today, they're
at the forefront of the conversation. That generally signals that a
chance in sentiment may be coming soon.
) is one of the country's largest diversified banks and one of our
portfolio's largest positions. It's not well-loved by the market.
Investors have been concerned that Wells Fargo may have to dilute
existing shares by raising capital to meet the more stringent
reserve requirement regulations. But analysts estimate that Wells
Fargo will post long-term earnings growth of about 14 percent.
We've conservatively estimated 8 percent growth. Even with this
conservative estimate, investors still receive almost $2 of value
for every dollar they invest in Wells Fargo. Even if one assumes
zero growth, investors would receive $1.20 of value for every
dollar. That's a compelling valuation.
How do you avoid value traps?
We look for stability. If you employ a valuation process that
relies in part on future data such as forward-looking earnings,
predictability becomes important. The stability of a company's EPS,
profit margins and growth rates becomes critical. If you have
volatility and unpredictability in your financial ratios, you will
have less confidence that your investment will achieve that
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