Surviving the financial meltdown has left the strongest names ready to monopolise the wave of public and private sector refinancing. But Richard Hemming still finds that a return to the heady valuations of the pre-crisis unlikely

Immediately after the explosive allegations from the US’s financial regulator that Wall Street powerhouse Goldman Sachs defrauded investors, Patrick Lemmens, the senior fund manager at Robeco’s New World Financials fund with 30 years of experience in the sector, knew exactly what to do with his stock: sell.

“Directly after the [Securities & Exchange Commission’s] announcement I went from overweight to underweight the stock,” he says. “You can’t fight politics.”

Other people had the same reaction. When the SEC made its announcement on 16 April 2010 the market pushed Goldmans’ stock down 12%, wiping out $11bn (€8.9bn) of value.
Since then Lemmens has bought back shares at much lower levels, to the point where his holding is now market-weight. He also says that he admires the investment bank, and that its operations fit one of the trends that he sees in investment banking. “Investment banks like Goldmans, Deutsche and Barclays fit the trend towards ‘flow monsters’,” he says. “These banks will profit from the need for refinancing of government and private sector debt - especially commercial real estate.”

We know that Goldmans was infamously involved in the refinancing of Greece’s debt in 2000 and 2001, leading some to believe that it entered the euro on false pretences. But Lemmens’ comments do echo those of a number of the financial sector specialists: financial institutions that have not needed external funding from governments have been able to take advantage of their rivals’ weaknesses by cherry-picking profitable divisions from distressed sales. It is in these companies that the fund managers are looking to increase their holdings.

Other financials-favoured sector specialists include banks that have both traditional and investment banking arms in Europe and North America. These include Santander, Deutsche Bank, Europe- and Asia-based Standard Chartered, Bank of America, which now owns Merrill Lynch and Barclays.

Also, rather than running scared, they are adamant that the Greek crisis is generating opportunities for investors in these global giants that are being sold down because of regional concerns. Carmel Corbett Wellso is a financial services analyst for Janus Capital and has been increasing its holding in Santander. “Stocks are being sold down because of excessive fear,” she says. “Santander was down 20% at one stage - yet only 30% of its retail earnings come from Spain.”

Funds also have been increasing their stakes in emerging markets plays that have been relatively unscathed by the crisis because their operations are focused around traditional lending. These financial groups have also been expanding. “As the healing process continues, it favours the winners, the ones that didn’t need to be saved,” says Fred Rizzo, European banks analyst at T Rowe Price International. “These companies took market share and took advantage of the situation.”

Earlier it was a case of a relief rally. The FTSE100 has rallied over 21% since July 2009, despite its wobble last month because of the Greek crisis and political uncertainty.And share prices across the majority of the financial sectors have recovered significantly, including those of banks and mortgage providers that had been bailed out by taxpayers. This is because, prior to these bailouts, there was the very real concern that the global financial system could collapse.

It is noteworthy that the majority of companies’ share prices are still well below levels reached during the bull market up to September 2007. Now any gains will be much harder to achieve and that hard reality of the post-fiscal stimulus period is sinking in, for both banks and shareholders. In most cases the banks that accepted money from shareholders are having to trim down and sell assets.

EU rules mean that financial services companies are often forced to restructure, which introduces execution risk. They also have to fix the problem of not having enough liquidity to meet the regulatory requirements. Meanwhile, banks that have been bailed out are losing talent to competitors, as well as other sectors of the economy, including their clients.

“The risk/return profile is not as attractive as it was when there was a dash for trash,” says Rizzo. “Now we’re into the long, hard grind period. You look at assets of these banks and the models have changed, their earnings power has been reduced. Also, there is an overhang of government-owned stock.”

Many investment managers believe that Goldman Sachs has been one of the beneficiaries of the financial crisis - even accounting for its problems with the SEC, which relates to a deal worth only $1bn. Four days after the SEC made its announcement, Goldman reported net earnings of $3.46bn for the three months to March, up from $1.8bn a year ago, and paid its employees about $5.5bn in compensation, equivalent to 43% of its revenue.

Corbett Wellso’s fund owns investment banks including Goldman Sachs and she says that it is “interesting” that Goldmans has been able to buy back shares when so many financial institutions are unable or restricted from doing this because of increasing capital requirements. “We own some US and European investment banks and are focused on the ones that have made market share gains, plus expanded their margins, like Goldman Sachs.”

Echoing the comments by Lemmens, she says that investment will benefit from the need for governments and companies to issue bonds. She also says that with regulations changing so radically in the wake of the crisis, there will be a lot of advisory work for investment banks.

But no bank of any type will reach pre-crisis valuation levels when many traded at levels of close to two times book value. Now relatively successful banks such as Barclays and JPMorgan are trading at between 0.9- and 1.1-times. The key reason is reduced profitability. For banks, this is mainly due to the increased capital requirements that are being introduced by regulatory bodies in the major markets. These are being led by the IMF, which is proposing two new taxes on financial institutions, one a ‘financial stability contribution’ to pay for “the fiscal cost of any future government support for the sector”. This will be at a flat rate, but will eventually be refined so that the riskier institutions pay more. The other is a ‘financial activities tax’, which would be levied on the sum of a financial institutions’ profits and the remuneration they pay.

From an investor’s perspective, analysts have already worked out the possible cost. Corbett Wellso says this should be 3-5% of banks’ earnings per share (EPS). The measures being proposed by the Obama administration in the US are harsher, she says, and could reduce EPS on banks in that market by as much as 15%. Dividends are likely to play a secondary role as banks look to shore-up their regulatory reserves and meet the requirement that they extend the duration of their funding from one year, prior to the crisis, to five years.

Another factor from an investment banking perspective is the pressure to move bespoke, over-the-counter derivatives products onto exchanges, where it is hoped they will be easier to supervise. “This type of business has been very profitable and the reduced margins for banks won’t be offset by increased volume,” says Corbett Wellso.

Associated with the increased regulation and lower profitability, is the shift to lower risk-taking by banks. This means a move back towards traditional banking. In this context, Rizzo says that banks will look to increase earnings by acquiring smaller rivals or divisions of rivals. “You’re likely to get more bolt-on acquisitions,” he suggests. “You’ll get deals that involve the sale of branch networks, of deposits, insurance businesses or asset management businesses.”

Funds are also purchasing stakes in those ‘niche’ financial services businesses that have been able to buy weaker counterparts. These include some private equity operations, as well as private banking businesses.