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Our Perspective on the Financials Sector1

by | Apr 14, 2025

A HISTORICAL LENS

Sprucegrove has always taken a bottom-up approach to portfolio management that is fundamentally based upon finding high quality companies at attractive valuations. When it comes to the Financials sector, we have historically favoured traditional retail and commercial banking franchises with leading market positions, strong underwriting histories, conservative management teams and well capitalized balance sheets.

Given these strict criteria, it is perhaps not surprising that Sprucegrove has been perennially underweight in the financial sector throughout most of our history; especially when large swaths of the companies within the sector are characterized by lackluster profitability, excessive leverage, limited growth opportunities, regulatory risks and prone to technological disruption. As has been confirmed by an independent analysis2 on our past performance, this underweight to financials has served as a tailwind to our performance in most years.

RECENT DIVERGENCE

At the start of last year, following strong performance by lower quality European and Japanese Financials, we presented analysis entitled “Safety in Financials” which many readers may recall seeing. This highlighted that the Financials in Sprucegrove’s portfolios have higher returns on equity (ROEs), superior Tier 1 capital ratios and lower financial leverage, on average, compared to the Financials that have been driving the outperformance of the Sector.

At the same time that these lower quality financials were outperforming, we eliminated two of the banks in the Fund, TD Bank and Banco Bradesco, for quality reasons.  Both of these factors exacerbated the underweight position in Financials to a level that was disconcerting to us. What had been a tailwind for the portfolios became a meaningful headwind and source of underperformance.

RECOGNITION AND RESPONSE

Given our widening Financials underweight and higher exposure in the remaining Financials given strong price appreciation, we felt it was important to address these two factors. To be clear, while sector and country weights remain a residual of our bottom-up process, we also recognize the potential risks that this widening gap between the index and portfolio weights in Financials presents. Equally, the team understood that addressing this without compromising on quality or valuation would require a wider lens beyond the traditional banking franchises we have historically favoured.

As a result, our response to this situation was multifaceted and involved the efforts of the whole investment team. We conducted extensive idea generation in both traditional areas and new niches within the Financials Sector. Nearly every analyst conducted research on at least one new company in the Financials sector and we engaged with the management teams of many of these new portfolio candidates. The result of these collective efforts has been the addition of twelve new Financials names to the working list and four new holdings in the portfolio.

As can be seen in the summaries included below, each new addition brings something unique to the portfolio.

FinecoBank is a leading investment platform, brokerage and retail bank in Italy. Quite a distinguishing characteristic of this bank compared to our other financial holdings is that, excluding its advisory centers, Fineco is a completely online bank with no physical branch locations. Given its superior technology in its trading platform, it facilitates ~27% of stock trades on the Italian stock market, the most in the country. Fineco has grown its market share every year since it went public and given the highly scalable nature of its model, its cost to income ratio has declined meaningfully since 2011.  The company also offers a unique advisory model which allows its network of financial advisors to offer funds from highly recognized asset managers rather than only those manufactured by the bank. Fineco’s success is a function of its superior technology trading platform, unique investment advisory model, and low-cost banking offerings. FinecoBank was purchased at a projected ROE of 24%, dividend yield of 4.1%, P/B of 4.6x and normalized P/E of 19.3x.

Nordea Bank was founded through a series of mergers among 4 well-regarded single country banks in the Nordics: Nordbanken (Sweden), Merita Bank (Finland), Unidanmark (Denmark) and Kreditkassen (Norway). It is the largest bank in the region and remains to this day the only truly pan-Nordic bank, with roughly equal contributions from each of the 4 countries. Nordea is widely considered top tier in terms of safety, a well-earned reputation based on excellent credit performance since inception. It is also acknowledged as being ahead of the competition on IT infrastructure robustness and capabilities, giving it advantages on cost as well as business agility. Its business mix is well-balanced across retail and commercial banking as well as interest and non-interest income lines of revenue. The management team is well-regarded for its customer focus, operational skill and preparedness for growth while having the patience to wait for the macro cycle to re-accelerate. Nordea Bank was purchased at a projected ROE of 13%, dividend yield of 8.0%, P/B of 1.4x and normalized P/E of 10.7x.

Paragon Banking Group is a specialist bank focused on lending to professional landlords in the U.K. buy-to-let market. Their niche in professional landlords is attractive because the need for manual underwriting in this market limits competition and leads to better yields; yet they tend to be high-quality borrowers, characterized by strong collateral and long-term orientation. Paragon has unique advantages in serving these customers, including internal receive-of-rent and surveyor functions; 30-years of experience underwriting multi-exposure mortgages; and longstanding relationships with specialist distributors. Despite the attractions of this sub-segment of the U.K. lending market, it is largely a duopoly between Paragon and another peer given this niche is not large enough to justify all the heavylifting that would be involved by the U.K. high-street banks to pursue it. Paragon Banking Group was purchased at a projected ROE of 13%, dividend yield of 5.5%, P/B of 1.1x and normalized P/E of 8.4x.

Julius Baer (JB) is the second largest Swiss private bank and top ten globally. As a leading bank, JB benefits from scale, a reputation of good service and longstanding client relationships.  As a private bank JB has unique characteristics that differentiate it from traditional commercial banks. The company is focused on wealth management of high net-worth individuals and its products and services tend to be quite different from traditional banks. Additionally, the majority of its earnings come from commissions and fees and are therefore less exposed to interest rates and more correlated to financial market growth and trading activity. Julius Baer was purchased at a projected ROE of 12%, dividend yield of 4.3%, P/B of 1.9x and normalized P/E of 15.4x.

[1] Source: Sprucegrove, MSCI, FactSet, as of 3/31/2025
[2] In September 2024, Sprucegrove retained the services of Cabot to obtain investment-related analysis which confirmed that our historical active weight in the financials sector (consistently underweight) has mostly resulted in positive allocation effect (a full copy of this analysis is available upon request). Founded in 2004 and headquartered in Boston, Cabot uses proprietary patented analytics to help equity portfolio managers and research analysts better understand their skills, investment processes, and behavioral tendencies so they can apply pinpoint refinements to the way they buy, sell, and size assets. In addition to potentially generating stronger results, these investment professionals gain deeper self-awareness, streamline their investment processes and build stronger relationships with their investor-clients aided by compelling charts, graphs and other communication tools. FactSet Research Systems Inc., trading as FactSet, is an American financial data and software company headquartered in Norwalk, Connecticut, United States. The company provides integrated data and software.

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