Bank on it: The case for investing in banks

In 2001, Polaroid filed for bankruptcy. Despite the many scientific breakthroughs of its visionary founder Edwin Land, and despite creating and dominating the instant photography market, Polaroid was blindsided by the inexorable rise of emerging technologies, most notably digital photography, with which it struggled to compete. This, truly, captures the risk of corporate obsolescence: the risk that technological innovation will overtake your core business, rendering you stuck in the past and unable to keep up.

In a recent article penned in the Financial Times,[1] famed fund manager Terry Smith cited this technological obsolescence risk as one of the reasons he would not consider owning shares in banks which, in his view, are precariously susceptible to disruption from new fintech startups. The two other core arguments that he put forward were (i) the inherent leverage of banks, with thin slivers of shareholder capital propping up a large asset base and (ii) the inadequate returns that banks have historically provided shareholders in compensating them for that risk.

As the Polaroid case demonstrates, however, the risk of technological obsolescence that Mr. Smith identifies is not one unique to banking. In fact, the appropriately high regulatory oversight of the banking and financial sectors make it very challenging for new companies to take meaningful share from incumbent banks. This perhaps insulates banking from the obsolescence threat more so than some other sectors, where competition is fiercer and barriers to entry are lower, such as consumer products. Whilst many fintechs have been launched in the past decade to much fanfare, the core banking landscape in most countries, and certainly the UK, has not shifted much as a result: NatWest, a large UK retail bank that we own, had 19 million UK customers in 2022, the same number it sported in 2016.[2] The story is the same with the other large UK banks, with scant evidence of mass customer churn.[3]

What is happening, and a point that investors afraid of fintech innovation forget, is that banks are simply incorporating and adapting fintech approaches to change the way they interact with customers. This not only neatly heads off the risk of technological obsolescence – with the well-funded banks able to put substantial resources into such effort – but makes these processes more pleasant and efficient for customers, likely increasing consumer experience and retention, and lowering costs to deliver products. At NatWest, for example, there were 10.1 million active digital users in 2022, with 8.9 million on the mobile app (more than double the 4.2 million in 2016) and 63% of all Retail customers exclusively using digital channels, requiring no human input whatsoever (up from 58% just two years ago).[4] At the same time, where customers need further support, the bank offers AI virtual assistance, resulting in just under 50% of customers resolving their issue with no need for human (read: expensive) intervention. In 2022, this amounted to a little less than 5.2 million customer interactions with NatWest which were started, conducted and resolved fully autonomously, with no people from NatWest customer support involved.[5] With the well-heralded introduction in 2023 of newer, more capable and enterprise-ready AI tools, it seems highly likely that this rate may continue to improve, rewarding shareholders and customers with the improved productivity that novel technologies bring. The same story is true across the wider banking sector where retail banking customers and investors have come to expect their banks to keep up the pace of improved technological capabilities. In such an environment, it is puzzling to accuse these businesses of ignoring, or being incapable of responding to, technological innovation.

Issue might be taken, too, with a sweeping dismissal of a business model based on a select five-year period of poor returns on equity from a representative index. Firstly, it is worth pointing out that it is only over the very long-term that the returns investors experience line up with the returns the business makes on its equity base: when businesses change hands at fractions (or large multiples) of their book value, the price paid for ownership can amplify or dampen the returns investors reap. In the same way that we would argue that investors bid away high teens return on equity by paying eight times book value for a company, we would argue that investors can generate superior returns by buying a 10% return on equity company at half of its book value (thus generating a 20% earnings yield on their money). Simply dismissing a business model out of hand, without paying attention to the price at which that business is on sale, is an abdication of one of the key jobs of an active manager.

Another key job of an active manager is to find and own the very best investment opportunities that their relevant area of focus affords them: dismissing a large number of companies, based on an assessment of the returns of the sector index, would again seem to overlook this imperative function. Even if banks broadly have performed poorly, as measured by an index of choice, that is no reason to conclude that the banking business model is therefore poor, and that there are no standout performers to be invested in. An easy example is US behemoth Wells Fargo, which has earned an average of 13.3% return on equity in the 23 years since 2000, inclusive of the catastrophic industry experience in the Financial Crisis (during which it still made money).[6] Indeed, if investors both recognised this impressive performance, and took advantage of the low price-to-book opportunity offered by the crisis, buyers in 2009 would have earned a total annualised return of 17.7% in the subsequent five years.[7] Dismissing banks outright is to dismiss these return opportunities, not something we feel any need to do.

The counterpoint raised by some investors is that, whilst it is true that these high return opportunities do exist for bank investors, they do not sufficiently reward shareholders for the risks they bear, given the highly leveraged nature of the business. We disagree. Whilst it is no doubt the case that leverage brings with it risks, it is important to consider what companies do with the proceeds of that leverage, and how they employ it in the context of a wider business model, before reaching conclusions about how risky that borrowing really is; after all, freight trucks have much larger engines than Ferraris, but don’t travel at speeds that endanger the driver nearly as much.

For example, a company that borrows money to purchase specialised equipment, and construct a factory that can be employed only for the manufacture of a single product category, seems to us to be taking far more risk with that money than a bank, which deploys its borrowings across a broad array of assets, many of which are high-quality, low risk and deeply liquid, tradeable almost instantly to meet client redemptions.[8] One need only look at default rates by sector to observe that banking has one of the lowest cumulative default rates over a ten-year horizon across sectors at 4.2%, whilst durable consumer goods (25.6%), retail (24.3%) and even healthcare (10.4%) all sport far higher risks for investors.[9] We believe It is true that leverage requires caution, and that bank management teams that do not proceed with that caution can wound shareholders, occasionally fatally. The same, however, is true of all business models, and bank management teams seem to have internalised the lesson more than most, if a fifty-year record of corporate bankruptcies is any guide.

It is also finally worth rebutting the claim that even healthy, well-managed banks can be wiped out by bank runs, a topic which is top of mind in light of the recent SVB debacle. However, in the modern central bank system in which most economies operate, this is simply not the case: to paraphrase the famous Lombard Street maxim of Walter Bagehot, the function of central banks in times of crisis is to lend freely, against good collateral, at penalty interest rates.[10] If you have intelligently managed your banking operation, and have sufficient quality on the asset side of your balance sheet, then you can borrow against these high-quality assets in times of distress, and can afford to pay the penalty rates for doing so. A glance at the influx of deposits into the strongest banks over the past few weeks, in the wake of the SVB concern, is a worthwhile point of corroborating evidence that strong banks benefit at the expense of the weak.

We believe that there is a clear investment case for selected, well-managed banks who are able to respond to technological change with the dynamism demanded of a start-up, whilst at the same time managing their balance sheet with the conservative caution that is needed when employing borrowed money. The banks that we own, in our view, meet and exceed these requirements, and offer investors, at current valuations, excellent prospects for future returns.