The UK bank shares I’ve been buying

Laura Foll, co-manager of Lowland Investment Company, names three FTSE 100 shares she has been recently adding to, including banks. Foll also runs through how the trust invests, and gives her views on a key risk for investors in 2022 – rising levels of inflation. 

Kyle Caldwell, collectives editor at interactive investor: Hello, today I’m joined by Laura Foll, who is the co-manager of the Lowland Investment Company (LSE:LWI). Lowland invests in market leading businesses that are out of favour, so Laura, how do you ensure that you are not investing in a potential value trap, what sort of qualities do you look for in addition to the valuation?

Laura Foll, co-manager of Lowland Investment Company: It’s a great first question, and there are lots of different things that we look for, but I would say the number one thing that we always have to bear in mind is, is this a company that’s growing, is it a company that’s growing those sales and earnings, if not now, then can we see a clear path to it. So to give a very recent example, a new position in the trust over the last year, 18 months or so, would be BT Group (LSE:BT.A), it’s something we’ve not held for several years prior to that.

It would tick the valuation box, and would have done for quite a while, but what we think is different now, potentially different, is that they are spending very large sums in terms of fibre to the home rollout, and what that gives them the opportunity to do is potentially grow sales and earnings. And on a modest basis, we’re talking about a telecoms company, it will be modest, but it does give that option for growth that we couldn’t see over recent years. 

And it’s really that that’s given us the opportunity to say, OK yes, this could fit for Lowland now, it has the valuation, and potentially the sales and earnings growth as well. So of course, there are other factors, but that is the number one thing that we look for.

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Kyle: And how is the investment trust positioned at the moment, it invests in UK equities so what’s the current split between large-cap, mid-cap, and small-caps, and is it those shares outside the FTSE 100 companies that you find particularly attractive?

Laura:  So if you go back over history for Lowland, a very rough average would be that we hold a third in smaller companies, a third in medium sized companies, and a third in large companies. At the moment, we have slightly more than that historic average in larger companies, so we have roughly 40%, around 40% in the FTSE 100, roughly 20% in the FTSE 250, and then the remainder in smaller companies. 

I think it’s important to note that me and James don’t manage the fund with a target in mind for those index weights, it’s very much bottom up and where we’re finding those opportunities. For example, the FTSE 100 weight is slightly higher than historic average at the moment because we are finding opportunities in banks, and they tend to be the FTSE 100. And also, a new position in the team, which I mentioned, which again, it’s in the FTSE 100, but we would have found it equally as attractive if it was in the FTSE 250. So we have slightly more in the 100, but I wouldn’t say that that’s us saying the FTSE 100 is a buy, it’s us saying that’s where we happen to have found some opportunities recently.

Kyle: You mentioned banks, is that a particular sector that you’re finding value in at the moment, could you run through a couple of banks that you hold, and also, are opportunities becoming a bit harder to identify, given that there’s not been a notable stock market correction since the first quarter of 2020?

Laura: Sure, so maybe starting with the banks, it’s an area that we have been adding to over the last 12 months, or so, to give a few examples we’ve added to the holdings in NatWest Group (LSE:NWG), and Lloyds Banking Group (LSE:LLOY), and that addition has really come about because of a combination of valuation reasons, these companies are still trading in all cases at a discount to book value, that would be lower than their historic average valuation. 

It’s not just valuation, it’s also that we think the macroeconomic backdrop is such that these companies are well placed to benefit when the economy is growing. So we’re in a period where, not just the UK economy, but the global economy is recovering from the pandemic. Normally, banks do well in that kind of backdrop, you normally get good levels of loan growth with relatively low loan losses, that’s certainly what bank results are suggesting at the moment, that those loan losses are low. 

And also, we’re getting to a point where dividends were explicitly banned by the regulator here last year in 2020, they have since come back, and these banks have capital – excess capital relative to what management are saying they target. So we’ve got good dividends already, but we could potentially see more capital returns, the likes of special dividends or potentially share buybacks as we go into next year.

And then just to your point around the market, the market has risen since the lows of the pandemic, definitely. We have definitely seen a rerating of the portfolio, and of the market as a whole, but we are still seeing good value opportunities. I think what people might be missing is that a lot of companies during the pandemic, looked really hard at their cost basis, this was such a severe demand shock for a lot of companies. They had to look internally and think, OK which of these say manufacturing facilities is the least efficient, which of these can we close.

And you’ve seen a number of companies, particularly I would say our industrial companies have reduced their cost bases materially. And what you’re now seeing is sales recovering, and I think what people could be missing, especially because there’s a lot of noise at the moment around cost pressures is that margins could be higher coming out of the pandemic, than they were going in because businesses have cut costs and worked out how to run those businesses more efficiently.

Kyle: And back to banks, which ones are owned in Lowland?

Laura: Within Lowland we have almost all of the large-cap banks, so we would have HSBC (LSE:HSBA), we would have Standard Chartered (LSE:STAN), we would have NatWest, and Lloyds, and Barclays (LSE:BARC), so we have all of the FTSE 100 banks within the portfolio.

Kyle: And heading into 2022, is inflation the main risk that investors need to keep a very close eye on?

Laura: I’d say inflation is definitely one of the main risks that I think about, and that has already become evident to a degree in the earning season that we’re in now, which is Q3 starting to see some companies struggle to immediately pass on cost pressures, with the most imminent being freight, particularly, and commodity pressures more generally, things like energy, utility bills are also hurting.

So it’s been a very, not just high commodity prices, and high input cost pressures generally, but very volatile commodity prices that are making that backdrop quite challenging. It’s a nice period for demand for company management teams, but I don’t envy them in terms of trying to manage their cost base. And what you’re hearing some companies say is, look we will manage to pass this on, but we can’t do it in a month, we need three months, we need six months, to have the discussion with these customers and say, look we need to pass this on, we need to do something here.

So those discussions are happening now, but you are seeing some shorter-term margin pressure, and I think that will continue into 2022. So it’s something that is definitely front of mind for us, and it’s probably one of the main risks. I would say the way to think about mitigating that risk, is or at least partially mitigating that risk, is to have companies that are really specialist in what they’re producing, whether that’s a service or a product.

So that when they’re having those discussions with customers, the customers are saying, well actually, you know what I need this product, and if you have to pass on this price rise then fine, but actually, you know what, I need this valve, I need this component, whatever it is, to get my production process going. So I’ll have to take this price rise and we’ll have to work together to make it work because you are the market leader, or one of the market leaders. It’s really important not to have commoditised producers during this type of environment. 

Kyle: Could you name a couple of examples of companies that, as you’ve just mentioned, are specialists in terms of their products or services, and have – therefore have pricing power, and the ability to pass on rising levels of inflation?

Laura: I mean, one of the biggest sectors in Lowland, or certainly our biggest overweight position would be within the industrial sector. And the industrial companies that we still have listed in the UK are not widget manufacturers, they are very specialist engineering companies that have, in order to survive, have had to become very specialist market leaders in the areas that they’re in.

And these types of companies, we’ve had a couple report third quarter earnings so far, and actually the evidence would suggest, the evidence we have now would suggest that they are managing to pass on these cost pressures so far because this small component that they’re making is absolutely essential to within very big supply chains. So far, the evidence is good, but it’s still quite early days in terms of this cost price spike that we’ve seen.

Kyle: And with inflation comes the possibility of future higher interest rates, has that been something that you’ve been thinking about at all, and was that a factor behind increasing exposure to banks, for example?

Laura: It definitely was a factor, so going back to why we were adding to the banks, it wasn’t just valuation, it’s also thinking about where they sit within the portfolio, and we need to have a portion of the portfolio where if that interest rate rise does happen, we all know that interest rates are at exceptionally low levels and the moment, so presumably an interest rate rise will happen, the scale of that, the timing of that, we don’t know, but presumably there will be an interest rate rise at some stage.

And we have to have a portion of the portfolio that does well in that backdrop, the banks have obviously had headwinds for the best part of a decade, in terms of interest rates going down, and down, and then staying at exceptionally low levels. I think people have almost forgotten that interest margins for banks can occasionally go the other way, it’s been such a long time since we’ve seen that, I mean almost my whole career, we’ve seen interest rates going one way, and actually they can go the other way, and that would hopefully be beneficial to bank margins when it happens.

Kyle: Laura, thank you for your time today.

Laura: Thanks very much, thanks for having me.

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