Discipline in the market means you have to say “no” far more often than you have to say “yes”. Often good is not good enough. We felt exactly like that when we hedged the John Hancock Financial Opportunity Fund (NYSE: BTO). The fund hit the right grades and had great managers, a sector we liked (on a relative basis) and performed well. It also used relatively modest leverage, which is increasingly lacking in the world of closed-end funds. Still, we stayed away because a few factors made us feel uncomfortable. More specifically, we said,
We are impressed with what we are seeing, but will only look to give this fund a Buy rating once we see a market correction alongside a revision to a 0% premium to NAV. We remain neutral for now.
Source: The right fund, but not the right time
Although we received some “boos” from the fans (you’re not really doing your job if you don’t receive them), we remained unmoved. The decision was correct as the fund not only generated negative returns but also lagged the market as a whole.
We are looking today to see if there is any joy to be had in this quality fund.
A look at the fund’s current top 10 holdings shows that the household names are still in place. Blackstone Inc. (BX) continues to hold the top spot, followed by a handful of regional and national banks.
One notable change is that the KKR & Co. Inc. (KKR) which has dropped out of second place as we saw it last time we covered this. With banks dominating the screen, the underperformance was expected. The sector saw a moderate decline with yield curve inversions dominating news releases. While we think a slowdown is highly likely, we don’t see the recession fears that everyone is currently seeing. Inventories remain extremely low across the board and rebuilding will take at least a few quarters. We should add that slight inversions are not at all uncommon at this stage of the cycle.
Of course, in the longer term, recessions are obviously inevitable. The real unemployment rate is close to a 4% level and you are obviously getting to a point where this number has no choice but to increase. Purchasing financial products therefore requires ensuring that you are not paying too much at this stage of the cycle. Are you? One way to look at this is to see how these financial values trade relative to a price normalized to the tangible accounting multiple. We picked three random picks from the top 10, Fifth Third Bancorp (FITB), Bank of America (BAC), and JPMorgan (JPM).
Recent stock price declines have corrected some of the scum that we say was in early December, but no one can look at those multiples and remotely call them cheap. Keep in mind that even if we don’t see an outright recession, the flattening of the curve will certainly put pressure on earnings at the end of 2022 and 2023. These banks will have to raise interest rates quickly to competing for client funds and loan applications will also slow down. In such an environment, the net interest margin will flatten quickly. Therefore, P/E ratios and 1-year earnings remain the most useless tool to gauge buy points for banks (and most stocks).
A good aspect of the recent decline is that the fund has moved to a lower premium. The red dot indicates the premium when this fund was last hedged.
This is actually the main reason if you bought in late December you are in pain. Much of the decline was premium compression. Buying without considering the premium is a great way to get exceptionally low total returns. At the current rate of 3.11%, at least you’re not paying through the nose. While it’s no longer the headwind it was three months ago, we still believe this will be available at a discount across the board.
We like the banks and think the unwinding of the Fed’s balance sheet will give investors some spread on the yield curve. We will write more about this topic in a separate article. For now, we are selective and choose where financials are most attractive. For example, we found the reinsurance segment particularly cheap at the end of January and seized the opportunity of our offer on RenaissanceRe Holdings Ltd. (RNR). The stock was trading at less than 1.2 times tangible book value at the time and offered an attractive opportunity to take over the company by selling the $155 cash secured put options.
Another reason we picked this one was that it was yield curve agnostic. Insurance and reinsurance companies will benefit from a general rising rate environment as their investments will bring in more revenue. They really couldn’t care about the yield curve. It’s also likely why Warren Buffett chose another reinsurer we’ve highlighted. Coming back to BTO, we’re tempted to give it a higher rating, but we’ll stick to the neutral/holding rating for now. Valuations are definitely heading in the right direction and we have certainly found a few banks that we have made offers for. The fund lacks exposure to the insurance sector and this is where we find better overall value. This one remains far from a purchase for us.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.