Should You Bet on the Bank Stocks?
February 27, 2017, 2:26 pm
Following all the media excitement about the “Trump Trades” and the sectors to be in (or stay away from) right now, I’ve gotten a lot of questions from investors on the street about them. Financials were one of most asked about, so I thought I’d spend some time talking about them today.
When you hear news about hope for earnings growth in financials, it’s referring to cyclical growth, increased lending as the economy advances and improvement in interest margins as interest rates rise. While loan growth has been on the upswing, a lot of changes that have been in company earnings have reflected cost controls.
In addition, gains in long-term interest rates remain elusive, and I believe investors looking forward to a steeper yield curve that brings higher net interest margins could be disappointed. Net interest margin for banks is actually a lot more complicated than the notion that Federal Reserve tightening will lead to higher profits; much will depend on how a bank positions its balance sheet for borrowing and lending.
Financials are quintessential value stocks versus growth stocks, accounting for 25% or even more of the Russell Value Indexes. They fit comfortably in the value style of investing, as they have historically sold for price-to-earnings and price-to-book ratios meaningfully lower than market averages. The low valuation reflects the lack of internal growth in the industry, and more importantly, the above-average risk in investing in financials.
This risk stems from the extensive use of financial leverage. While the days of holding $30 of assets for only $1 of equity are over, financials still require leverage to be profitable. For example, JPMorgan Chase (JPM), which is possibly the best capitalized large-cap bank, has $2.49 trillion in assets and $207 billion in tangible equity for a leverage ratio of 12:1. So if the value of JPM’s assets declined by 8%, either by loan losses or a decline in the value of securities held, the company’s tangible equity would be wiped out. This is an extreme example that would only occur in a depression, but I want to demonstrate how volatile balance sheets can be for financials and why they sell at low valuation ratios.
It’s also important to keep in mind that when banks prepare their financial statements, they make wide use of estimates, such as the amount of expected loan losses and in some cases, the value of securities held. Any error or underestimation of potential liabilities could have a significant impact on the final statements. This factor also tends to depress valuation ratios.
In addition, the earnings power companies like JPM or Bank of America (BAC) are expected to achieve is dependent on economic factors instead of secular growth, and the economic conditions needed to produce this kind of performance may not even occur. With the average bank stock with a market cap over $1 billion trading at 14.1X 2018 EPS estimates, a lot of the improvement has already been priced into the group.
Of course, this doesn’t mean that you should stay away from this sector right now. Financials can make for great longer-term holdings, especially with the Fed likely to raise interest rates three times this year. I just recommend waiting to grab them on pullbacks first.