Market review

March was an excellent month for equity markets, led by Europe, as investors continued to buy into the narrative of a soft landing on the pick-up in economic data. The US equity market, while lagging, made further all-time highs, with the Japanese equity market held back by currency weakness despite the Bank of Japan raising interest rates for the first time since 2007. Against this background, financials outperformed, rising 4.4% as illustrated by our benchmark index, the MSCI All Country World Financials Index, with the Trust’s net asset value rising by 4.8%.

Nationwide bid for Virgin Money

A surprise in March came in the form of UK bank consolidation, with the announcement that Nationwide Building Society, the UK’s largest mutual, had agreed a £2.9bn deal to acquire Virgin Money UK (Virgin Money). We believe the Board of Virgin Money failed to explain why they were selling the bank for such a low valuation. At best, it is not a great advertisement for the medium-term outlook for the UK banking sector if a so-called challenger has thrown the towel in for a cash bid.

When Virgin Money was first acquired in 2018, by Clydesdale and Yorkshire Bank Group (CYBG), it was then effectively the remaining rump of Northern Rock, with the combined group taking the Virgin name. At the time it was described by one anonymous fund manager as “two drunks propping each other up doth not make for good bedfellows”. Long-term shareholders would agree as even taking into account the takeover premium paid, shareholders have lost money over the six years, as well as underperforming their UK bank peers by over 40%.

UK bank holdings

The Trust’s two UK bank holdings are OSB Group, which is primarily a buy-to-let lender, and Barclays, which is a more recent purchase where we see sentiment as too negative. Bar a brief period in 2023 when we side-stepped a profit warning, we have owned OSB Group since it IPO’d in 2015 but were caught in March by lower guidance on net interest income than had been expected, which knocked the share price. Nevertheless, since IPO OSB Group has grown its book value per share by over 4x while returning 181p per share in dividends, which compares with an IPO price of 170p per share, equating to a compound annualised return to shareholders of over 12% per annum.

OSB Group has benefited from being incredibly efficiently run, with operations in India leading to a market-leading cost-to-income ratio while along with Paragon Bank, another buy-to-let lender, operates in a very attractive market that is much less commoditised than the wider UK mortgage market.

The flipside of that equation is that its shares have derated materially – a problem for all UK banks. Today it trades on less than 0.7x price to book which, for a business that is expected to deliver a high-teens return on equity, we see as mispriced. Why is it so much better than its larger peers? OSB Group has benefited from being incredibly efficiently run, with operations in India leading to a market-leading cost-to-income ratio while along with Paragon Bank, another buy-to-let lender, operates in a very attractive market that is much less commoditised than the wider UK mortgage market. For now, we see no reason for that to change and used the opportunity of poor communication around the outlook for 2024 earnings to increase our holding.

Barclays is a shorter-term trade. For too long it has been a value trap for shareholders and its recent travails have been well documented in Philip Augar’s The Bank that Lived a Little that takes its journey back to 1983 and the fateful decision to buy BZW and enter investment banking. Nevertheless, sentiment has been too negative with prospective returns inching higher over the past two years but the shares only recently starting to participate. At a strategy day management promised to return to shareholders at least £10bn but sell-side analysts have not bought into its profitability targets. Trading at around 0.5x book value per share, we do not think that matters as the bar remains painfully low, albeit for good reason.

Ireland

Our only holding here is AIB Group which we continue to like. The Irish banking market has become very concentrated following the exit of Danske Bank, KBC Group and Ulster Bank (part of NatWest Group) leaving only three banks that could be argued are genuine competitors. Ireland was hit very hard by the excesses of the Irish banks, most notably Anglo Irish Bank, in the run up to the global financial crisis, where mortgages were offered at 100%+ loans-to-value and commercial property lending was undertaken on equally weak criteria.

As a consequence of this, all the Irish banks have to carry much more capital than their European peers as their models include the losses from their incontinent lending practices of 15+ years ago, reducing downside risk but equally offering the potential for higher capital returns in future years. As with most European banks, their funding and liquidity metrics are much stronger and over the past couple of years their profitability has improved markedly due to the rise in interest rates, reflecting the limited pressure they have had to pass them on to depositors.

Reflecting the fact that it has been one of the biggest beneficiaries of higher interest rates, the reverse is equally true if interest rates were to be cut more than expected. While the bank has been extending its interest rate hedges to lock in higher interest rates, earnings revisions have also continued to be positive, reflecting the conservatism of the management team. In the longer term, we would expect the stronger performance of the Irish economy to lead to stronger loan growth too. Against this background, the bank’s shares trade at below 0.9x book value despite a double-digit return on equity forecast going forward.