finn-ancial Times finnCap Financials & Insurance quarterly sector note Q3 2020 | Issue 9 Highlights this quarter: Elevated uncertainty and volatility have been hallmarks of the last 18 months, with Brexit, the UK General Election and more recently COVID-19 all contributing to the challenges that face investors wishing to carve out solid and stable returns amid these ‘unprecedented’ times. With this is mind, and simulating finnCap’s proven Slide Rule methodology, we found the highest quality and lowest value stocks across the financials space, assessing how the make-up of these lists changed over the period January 2019 to July 2020, tracking indexed share price performance over the period as well as movements in P/E and EV/EBIT valuations. The top quartile list of Quality companies outperformed both the Value list and the FTSE All Share by rising +2.5% over the period versus -5.4% for the All Share and -14.3% for Value stocks. Furthermore, the Quality list had protection on the downside in the market crash between February and March 2020, and accelerated faster amid the market rally between late March and July 2020. From high to low (January to March), Quality moved -36.3% against the Value list at -45.5%, while a move off the lows to July was +37.4% for Quality and +34.0% for Value. There was some crossover between the Quality and Value lists, with 7 companies of the top quartile (16 companies in total) appearing in both the Quality and Value lists. This meant that a) investors could capture what we call ‘Quality at Value’ (i.e. this crossover list of 7); and b) outperformance of Quality was explained by the remaining 9 companies that appeared only in the Quality list. The ‘Quality at Value’ index returned +1.1% over the period – positive at least, given the backdrop, but low in nominal terms – while buying the 9 companies would have returned +3.6%. Drilling into the makeup of the Quality list, we found that c.60% of the companies were either from the exchanges or fund manager sub-sector, so screening for quality within these two sectors and investing in the top half of the list of 20 companies would have amplified returns further to +9.0%. For investors wanting the greatest returns with no mind for quality specifically, it would have been possible to simply focus on these two sub- sectors and buy the entire list of exchanges to return +33.5% or the entire list of fund managers to return +18.9%. While exchanges and fund managers provided the greatest upside over the period, the greatest re-rating was in the Value space, moving up from 8.0x to 11.2x on a P/E basis between January 2019 and July 2020. Indeed, this re-rating occurred steadily over 2019 suggesting that opportunities absolutely remain in the Value space across financials and must not be ignored as the economy enters a phase of recovery. Outside of just buying exchanges and fund managers, which as we have argued are exposed to strong underlying drivers post COVID-19 (see previous issue), we are attracted to other quality, non-fund manager/exchange companies and companies presenting value opportunities: Tatton Asset Management (TP: 335p, Buy), Nucleus Financial (TP: 170p, Buy), STM (TP: 53p, Corp), 1pm (TP: 45p, Buy), Charles Stanley, PCF Group, Manolete Partners, City of London Group (TP:300p, Corp ), S&U (TP: 3000p, Buy) and Frenkel Topping (TP: 50p, Corp). Nik Lysiuk Research Analyst [email protected] 020 7220 0546 This research cannot be classified as objective under finnCap research policy. Please visit www.finncap.com or the Research Library. finn-ancial Times Q3 2020 | Issue 9 finnCap Financials & Insurance quarterly sector note The bifurcation between Quality and Value over an 18- month period of elevated uncertainty, including Brexit, a General Election and more recently, COVID-19 Recent market volatility provides a stress test for an investor’s chosen strategy while identifying opportunities to tweak and refine it. With this is mind, we wanted to see how Quality holds up against Value in the financials space and found that the traditional view of Quality outperforming Value has held true amid both Brexit, General Election and recently COVID-19-related uncertainty (i.e. between 31 January 2019 and 30 June 2020). The top quartile list of Quality companies outperforms both the Value list and the FTSE All Share, rising +2.5% over the period versus -5.4% for the All Share and -14.3% for Value stocks. Quality downside is protected, while the upside accelerates relative to both Value (Fig. 1) and the All Share. Quality’s outperformance versus Value between 31 January 2019 and 30 June 2020 (+2.5% versus -14.3%) can be explained by just 9 stocks (Fig. 3): Premier Miton, K3 Capital, Jarvis Securities, Hargreaves Lansdown, Tatton Asset Management, FRP Advisory, SimplyBiz, Mortgage Advice Bureau and Nucleus Financial, which together returned +3.6% over the period. This is because the other 7 top-quartile companies (16 in total) across our Quality and Value lists appear in both categories, suggesting that investors in the financials space can buy what we call ‘Quality at Value’, by which we mean companies that appear on the crossover between the two lists. However, while this crossover list of companies outperformed the All Share (+1.1% versus -5.4%), the nominal return was low (Fig. 4). Drilling into the Quality and Value lists, we found fund managers and exchanges formed 56% of the Quality list in January 2019 and 63% in June 2020 (Figs 5 and 6). As we stated in the previous issue, we see these sectors as being the likely winners as the economy moves into a recovery phase following COVID-19. This begged the question whether investors over this period could have just bought fund managers and exchanges without screening for quality (though the sectors are characterised by high returns on capital). Indeed, holding all stocks in the exchange sector between 31 January 2019 and 30 June 2020 would have produced returns (ex- dividend) of +33.5%, while fund managers delivered +18.9% against the Quality focus of +2.5% (Fig. 7). So Quality outperformed Value but a blanket focus on exchanges and fund managers outperformed further. For investors that want to rely on quality in these uncertain times, it would have been possible to screen for it within these two sectors and return +9.0% (Fig. 8) against the overarching Quality return of +2.5%. We continue to see underlying drivers in the fund management and exchanges sector as forming a strong positive thesis that can provide attractive returns as the economy recovers from the measures taken to tackle COVID-19. While our top quartile Value companies fell further and recovered slower compared to Quality, our Value index performed well throughout 2019 and into early 2020, tracking Quality (Fig. 2). Value should therefore not be ignored as the economy recovers. From a valuation perspective, there has been a re-rating in both Quality and Value, which was more pronounced in the latter (Figs 3 and 14), suggesting that wider ‘value’ and non-fund manager/exchange sector opportunities continue to exist. We are particularly attracted to the likes of STM, 1pm, Charles Stanley and PCF Group. Outside of a strict Quality or Value focus, we continue to find attractive upside opportunities in the likes of non-fund management/exchange companies: Manolete Partners, City of London Group, S&U, and Frenkel Topping. 2 finn-ancial Times Q3 2020 | Issue 9 finnCap Financials & Insurance quarterly sector note Buying Quality protects your downside and accelerates the upside Figure 1: Value fell more quickly and recovered more slowly relative to Quality All Share Quality Value High to low -35.9% -36.3% -45.5% Move off the low 27.4% 37.4% 34.0% Source: finnCap Figure 2: Quality in the financials sector outperformed both Value and the All Share, rising +2.5% over the period against Value’s -14.3% and All Share’s -5.4% 120 110 100 90 80 70 60 All Share Quality Value Source: finnCap, FactSet, prices indexed at 100 on 1 January 2019 While Quality outperformed Value, the outperformance was explained by just nine companies that appeared in the Quality list and not in the Value list, because there was some crossover between the two lists (what we call Quality at Value). Those nine companies were as follows (the five in bold text indicate those stocks we were recommending in the last quarterly based on the thesis that exchanges and fund managers would be winners in the post COVID-19 environment): Premier Miton (move off the recent low +53%), K3 Capital (+26%), Jarvis Securities, Hargreaves Lansdown, Tatton Asset Management (+60%), FRP Advisory, SimplyBiz, Mortgage Advice Bureau (+52%) and Nucleus Financial (+37%). Figure 3: Outperformance of Quality over Value is driven by nine stocks 1.30 1.25 1.20 1.15 1.10 1.05 1.00 0.95 Q/V Source: finnCap. FactSet. Index of Quality divided by the index of Value 3 finn-ancial Times Q3 2020 | Issue 9 finnCap Financials & Insurance quarterly sector note Figure 4: The crossover of companies that appear in both Quality and Value lists means that investors can buy ‘Quality at Value’, providing a positive return of 1.1% against the Value return of -14.3% and the All Share return of -5.4% 120 110 100 90 80 70 60 01/03/2020 01/01/2019 01/02/2019 01/03/2019 01/04/2019 01/05/2019 01/06/2019 01/07/2019 01/08/2019 01/09/2019 01/10/2019 01/11/2019 01/12/2019 01/01/2020 01/02/2020 01/04/2020 01/05/2020 01/06/2020 01/07/2020 All Share Quality Value Quality at value Source: finnCap, FactSet, prices indexed at 100 on 1 January 2019 Aside from the nine stocks driving returns in the Quality list, there are seven stocks that appear in both lists, meaning that investors that like to pick up value can do so while retaining a focus on quality.