- By Dilantha De Silva
George Soros (Trades, Portfolio) is known for his uncanny ability to identify market trends earlier than many of his rivals. Over the course of his investment career, the guru has made many bold moves, such as shorting currencies, when the world was against him. In the majority of such instances, Soros came out on top and proved time and again that he has what it takes to beat the market.
The U.S. economy is setting up for a strong comeback on the back of positive news coming from the health care sector regarding a vaccine to fight the Covid-19 virus. This is a good enough reason to believe the financial services sector, including major banks, will thrive in the coming months as credit growth accelerates and inflation picks up. Soros, however, seems to be in disagreement. According to the third-quarter 13-F filing of Soros Fund Management, the guru has divested Bank of America Cor. (NYSE:BAC) and JPMorgan Chase & Co. (NYSE:JPM) and added new names such as Palantir Technologies Inc. (NYSE:PLTR) and The Walt Disney Co. (NYSE:DIS) to the portfolio. Even though all these transactions were completed on or before Sept. 30, meaning the guru might have changed his stance since then, there's reason to believe that Soros might be proven correct in his actions in the long run.
The asset allocation strategy sends a clear message
The guru has reduced his exposure to the financial services sector and increased exposure to the consumer cyclical sector in the third quarter, which is illustrated by the charts below.
This goes on to indicate that Soros had already envisioned a future in which the global economy expands well before Pfizer Inc. (PFE) announced an update regarding its vaccine candidate. His decision to divest banks, therefore, is unlikely to be reversed in the coming months. What this asset allocation decision hints at is the possibility of banks underperforming in the rebound phase of the American economy, particularly due to the unfavorable macroeconomic conditions for the industry.
Soros dumping bank stocks, however, does not mean that every value investor should follow him. Banks and other financial institutions might deliver positive returns in the coming year if the business sentiment improves. The question, however, is whether this sector will be able to beat the market.
The outlook for banks is gloomy
If the global economy recovers, banks that have allocated a higher-than-required amount as loan loss provisions might be able to reverse these accounting entries in 2021, which would prove to be a boost for net income. Operating conditions, however, are unlikely to improve meaningfully for two reasons.
First, interest rates are at historic lows, and the Federal Reserve seems to be in no rush to hike rates despite inflation picking up during the third quarter. Speaking to the media in early November, Fed Chair Jerome Powell confirmed that policymakers are likely to keep rates low at least through the end of 2021. A quick look at the dot plot released by the Fed in September further strengthens this case as it suggests rates will stay at or near the current levels through 2022.
Source: Federal Reserve.
According to data from Refinitiv, net interest margins of major banks have already contracted considerably, and the Fed gives no reason to believe things would be any different in 2021. For this reason, even the largest of commercial banks in the U.S. might find it difficult to expand their profit margins in the foreseeable future, which is a recipe for underperforming the broad market even if these institutions report stellar revenue growth.
Second, businesses that are willing to borrow to fund investment projects might look for bond markets as yields have fallen sharply since March. As illustrated in the below chart, option-adjusted spreads for U.S. corporate bonds have declined this year, in contrast to what happened during previous recessions. As a rule of thumb, option-adjusted spreads usually decline when business conditions are improving, and businesses are in a better position to service debt repayments. Loan loss reserves of U.S. banks, on the other hand, have increased as expected.
Source: The Financial Times.
This anomaly has made it easier and more efficient for large U.S. companies to borrow from bond markets without having to go through the bureaucratic processes of seeking funds from banks. Things are likely to remain the same next year, which is not good news for banks. Even if businesses decide to carry out the postponed investment projects by borrowing funds, banks might fail to report any meaningful credit growth.
The tech sector continues to remain hot
The largest tech companies in the world, such as Amazon.com Inc. (NASDAQ:AMZN) and Apple Inc. (NASDAQ:AAPL), are trading at elevated valuation multiples, which could be one reason why value investors want nothing to do with the equity securities of these companies. However, the bull run that started on March 23 has left behind many lesser-known tech names in the dark, and investors continue to remain oblivious to the lucrative returns associated with these companies. A cautious investor, therefore, might have to "sift the world" as Charlie Munger (Trades, Portfolio) says, to find opportunities that are yet to be discovered by the investing public.
In the eyes of Soros, Palantir Technologies Inc. (NYSE:PLTR) might be one of these companies even though they are still making losses. The company develops software platforms for the U.S. government to assist the country's mission to eradicate terrorism and help in other investigative operations. The company debuted on the New York Stock Exchange in October and has already appreciated over 50% as investors continued to embrace the company's artificial intelligence products. The unique feature of the company's product line is that there is no direct competition. Therefore, if Palantir secures more contracts, which is a possible outcome considering the adoption of technologically advanced systems to monitor threats to national security, the company would be in a great position to develop an economic moat surrounding its products, which could then lead to economic profits for many decades to come.
Unprecedented changes are taking place in every corner of the world as a result of the adoption of high-tech solutions by both consumers and governments to solve problems, and concepts such as the internet of things are gaining popularity at a rapid pace. Speaking to the Wall Street Journal in 2018, director of the MIT Initiative on the Digital Economy Erik Brynjolfsson said:
"This is a moment of choice and opportunity. It could be the best 10 years ahead of us that we have ever had in human history or one of the worst, because we have more power than we have ever had before."
The tech sector will continue to provide investors with opportunities in the coming months, but pay close attention to the valuation levels to determine companies that are trading at fair or cheap projected earnings multiples would be key to investing success.
Bank stocks are cheap for a reason. What the future holds for the financial services sector is not promising enough to trigger an investment decision for growth investors. A cautious investor looking to generate income, however, might find banks extremely attractive considering the expected return of dividend hikes and stock buyback programs in the next year. Best bets for growth-oriented investors can still be found in the tech sector, and Soros' recent investment decisions are a testament to this.
Disclosure: The author does not own any stocks mentioned in the article.
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This article first appeared on GuruFocus.