How is the recovery playing out globally?
We are seeing a kind of a push and pull that's happening in the markets today, between recovery and perhaps the fear of overly strong growth and inflation. I see some of this exemplified by the numerous bottlenecks and rising prices. Also, it's hard to get resources. I think by now you've all heard stories of shortages of everything from labor, semiconductor chips to just basic materials impacting companies' ability to satisfy demand.
On the other hand, there are still some lingering fears of Covid-19, its new variants, and the possibility of new lockdown measures. We are seeing a little bit of this in Asia, which is kind of restraining interest rates and combined yield. So you do have this interesting push-pull. That said, we are seeing many companies with robust business activity. Thankfully, the global economy did not switch on all at once, because the global economy is having trouble handling a phased reopening. You still have places in Asia that are not fully reopened. Even other places around the globe, like Australia and New Zealand, are sporadically pushing pause to deal with outbreaks.
Overall, what we are seeing in the companies we follow are conditions of strong demand, strong profitability. In fact, in select industries like the automobile sector, they cannot satisfy demand because of parts shortages and the strong demand. I think what you'll see is this demand will remain for some time.
What is your outlook on banks?
Certainly, this is an area over the last decade that has faced headwinds. For example, if you were a European financial you had low and slow growth. Or, if you were any global financial firm since the global financial crisis, you tremendously had to build capital on your balance sheet, which depresses returns, all else being equal.
Look at ROE (return on equity), the returns of the net income over the equity base. If the equity base has to grow because of regulatory reasons, that compresses the ROE. And the fact is, they have still been able, as a group, to grow earnings. Since the capital build has grown faster, this has had a depressive effect on the return structure of businesses. But I guess the positive to this is greater safety. They have more capital. They have the greater ability to absorb losses.
Another headwind has been low to no interest rates. Lending is a spread business. When you get really, really low rates, that impacts spreads over time. So companies have been hit with lower interest rates and spreads. What they've done is try to enhance earnings from other areas in financial services – whether it be asset management or consumer credit. This is one of the reasons why many of these companies, despite all of those headwinds, have been able to grow income.
Is there still value in European financials?
We believe so. Despite the fact they've been able to grow their income, their valuations have not at all grown. In fact, valuations today for European financials, generally speaking, are around where they were during the financial crisis. This is despite the fact that there is a stronger earnings stream now and balance sheets. In our view, European financials trade at a substantial discount to US financials.
Therefore, when you consider where interest rates are, and where the nominal yield of these financial institutions are today, we think there is a very good value case to be made.
Could fintech firms dent earnings of banks?
Fintech of course has made a difference in terms of how non-fintech firms operate, including buying a lot of these smaller fintech companies. But our general belief is fintech firms aren’t a major threat and won’t put a big dent in earnings. There are other barriers to fintech firms getting too big – one being a regulatory barrier.
However, there is always competitive pressure out there for any business and these banks are not immune to it, from either smaller or bigger rivals. Overall, we believe that we are investing with companies that are embracing fintech and will strive to stay ahead of competitors.
Does a global corporate minimal tax rate that the US Treasury and Biden are pushing with other nations make sense?
They're trying to get an agreement to around 15%. For the most part, with the exception of Ireland, most of the current rates are, generally speaking, above this rate. But the devil is in all of the details. Meaning this is the minimum rate, but what will the exceptions be? What will the allowances be? What will the deductions and the credits be? Therefore, I really don’t have a formal opinion until we see all the details. But generally speaking, I think a sovereign government should determine their own tax rates.
Frequently around the globe, there is a very, very large difference between tax rates and effective tax rates. Meaning there are all kinds of adjustments because of such things as R&D credits and investment credits. Therefore, until one sees the details, it's really, really hard to figure out how it will impact the companies in which we're invested.
How are you viewing China’s regulatory action on their tech firms?
What you are seeing is a more aggressive Chinese regulator, especially as it pertains to the tech sector and especially in finance and lending and capital requirements. That has put pressure on the Chinese ADRs (American depositary receipts).
There is a host of regulatory issues that are unclear right now. One of the things we've tried to do when investing in China is kind of stay away from industries that are undergoing significant regulatory change. Certainly internet companies at the periphery have seen some impact here over the last few months. Overall, we will continue to look at many names in China because tech is a rather important sector. But we have to find the right company with the right governance.
How about the Japanese government stepping in on corporate matters?
You are referring to the recent Toshiba accounting story, I suspect.1 This is one of the reasons we have difficulty finding value in Japan. Remember, our value definition is the price you pay for what you get. So it combines low price with high quality. One of the things that make Japanese companies less higher quality is that G in ESG. Governance tends to be somewhat weak where you have boards and managements that aren't prioritizing the creation of shareholder value through time. They respond to other things that to us are less important than shareholder value creation.