Dumpster Diving in the Financials Sector

Thursday, September 5, 2019

As we head into September, the stock market is making all-time highs, but many investors we speak to are worried about a recession.  Many investors think ten years of economic expansion suggests a recession is right around the corner.  We are not so sure.  While there are some headwinds in the economy: trade tariffs, health care costs, student loan burdens, significant disruption in retail businesses, we think the economy is in good shape.  Banks have not increased their high-risk lending relative to their capital as they did in past cycles.  We believe demographics continue to favor significant household formations, which is a driver of economic activity.  We still need faster economic growth to catch-up to long-term trend economic growth from when we were thrown off trend by the 2008-2009 recession.

The juxtaposition of the stock market making all-time highs and investors worried about a recession can be seen very clearly in the valuations of stocks in the Financials sector.  Investors are placing valuations on many Financials sector stocks like we are headed into a recession.  So, if you are more bullish on the economy like us, a very good way to express your economic optimism is to own some Financials sector stocks. 

Below we review some of the cheapest stocks in the Financials sector.  We believe investors have been avoiding these stocks because they fear we are headed into a recession.

Investment banks – GS, MS, JEF, COWN – Morgan Stanley trades just above book value.  Goldman trades at book value.  And, Jefferies and Cowen trade at significant discounts to book value despite being profitable.  We know that FICC and Equities trading is in secular decline.  Each of these companies are buying back serious amounts of their shares.  We believe there are different catalysts for each of these stocks, and we know there is serious upside to each of these names.

Online brokers – AMTD, ETFC, SCHW – The online brokers have lagged on interest rate fears.  These companies make a significant amount of revenues from the residual cash their customers have in their brokerage accounts.  They tend to pay very little interest on their customers’ cash balance, so each increase in interest rates has helped to expand their profitability.  With the Fed Funds Futures Market starting to price in potential interest rate cuts, investors have been placing lower valuations on these stocks.  If the economy is stronger than the market anticipates and the Federal Reserve only cuts once or twice, we believe the online brokerage stocks are priced attractively.

Asset managers – VCTR, VRTS, BSIG – The asset management industry has had a very disappointing stock performance.  Despite the shift from actively managed mutual funds to passively managed ETFs, we think there are opportunities in a few selected assets managers, such as VCTR, VRTS & BSIG, due to their extremely low valuations, strong cash returns, and attractive capital allocation actions.

Life insurance – LNC, PRU – The main reason for lagging performance has been their exposure to lower interest rates.  Life insurance companies have large investment portfolios that earn more money when interest rates are higher.  Life insurance companies are also capital intensive, and capital intensive companies have been out-of-favor in the current stock market cycle.

Consumer finance – SLM, COF, DFS, NAVI, ALLY, OMF – Consumer finance stocks are at a very interesting point.  They are priced as if we were going into a recession.  The consumer finance companies have higher returns (Returns on Equity, or “ROE”) and faster growth than the regional banks, but they trade at lower multiples than the regional banks.  I understand why they trade at lower multiples: the last recession was a consumer-led recession.  Historically, consumer finance companies had weaker liability structures than banks.  The banks funded with deposits, whereas the consumer finance companies were funded by the capital markets.  This is a weaker liability structure because the capital markets seem to shutdown every 18-24 months, and the funding of consumer finance companies seem to be in question.  Now the consumer finance companies have a stronger liability structure as many of them have bank subsidiaries.  Credit underwriting is an additional improvement in the structure of consumer finance companies compared to previous cycles.  Usually, at this point in the cycle, the consumer finance companies have weakened their credit underwriting in an attempt to gain market share.  We haven’t seen a material weakening of credit underwriting this cycle.  We think the companies are maintaining their underwriting standards because the previous cycle was so deep and painful that the management teams have learned their lessons.  We also think the next recession will not be led by consumers.  Before 2008, we had not had a consumer-led recession.  Based on the strength of the employment market and consumers’ balance sheets, we don’t see consumers leading the next recession.

European banks – CS, UBS, ING, BCS, LYG, RBS – In our opinion, there is no more hated segment of the stock market than European banks.  Negative interest rates and lackluster economic growth in Europe has kept sentiment negative on the European banks for years.  If you add the negative narrative that Europe never let their bad banks fail, then you have a recipe for low valuations.  What we believe investors are missing on European banks is their capital is well above their target levels, and they are earning returns (ROE) are above 10%.  One reason these European banks trade so cheap is the uncertainty around Brexit.  The UK based banks such as Barclays, Lloyds, and RBS trade at a valuation that seems very, very cheap.  But, nobody can predict how the UK will proceed with Brexit and how the UK economy will act during a Brexit.  Another angle to these low valuations is Swiss banks are getting tarred by the European bank brush.  The Swiss banks have two advantages over European banks; 1) the Swiss banks are very profitable in their home  market, and 2) the Swiss banks have more substantial operations in the US and Asia than their European peers.

Growth banks – WAL, SIVB, EWBC, PACW, CADE, CNOB, SNBY, WTFC, BKU – There are a group of high-growth banks that are trading well below the valuation range they traded for between 2014 and 2018.  These banks can generate loans, deposits, or both at high single-digits or low-double digits.  They currently trade between 8x and 11x Price-to-Earnings (“P/E”) compared to previously traded P/E which fell between 12x and 23x.  We believe there are two main reasons this group is trading at such low valuations:

1) Each of these names are asset-sensitive, which means they would benefit from higher rates.  With the Fed Reserve refraining from further interest rate increases and possibly cutting rates, investors have stepped back from owning these stocks, and

2) Some investors believe the organic loan growth at these banks may come from poor underwriting. 

After all, it seems like the banks most likely to blow-up during a recessionary cycle were some of the fastest growers in the previous cycle.  Maybe one or two, or all of these banks, have potential credit problems.  I believe this is an interesting but potential high-risk area to look for opportunity.  I don’t think each of these banks will have credit problems, especially given my constructive view of the economy.  I am more mixed on the issue of these banks being asset sensitive.  On the one hand, I believe any rate cuts will be limited, and organic growth will continue to drive earnings higher.  On the other hand, a rate cut will take away some very high margin revenue, and the prospect of a 3% Fed Funds rate seems very distant.

Large regional banks – BAC, WFC, BBT, PNC, FITB – We believe the large regional banks are compelling at this point.  They trade at 9x to 10x this year’s earnings, earnings estimates have been increasing despite the flat yield curve, and they are all buying back a lot of stock at prices we think are below intrinsic value.  We believe the large regional banks have strong consumer retail franchises.  They have developed these franchise over the past 30 years, and switching costs for consumers seem high.  Consumers have their routines with their money; they use the same ATMs, they have their online bill payments setup, and they have automatic payments set up in their checking accounts.  All of these items raise the bar for consumers to switch banks.  Given that the large regionals are not competing for deposits based on price, we believe their consumer franchises are sustainable.  On credit, we believe the large regional banks are in a strong position.  We don’t believe they have taken excessive risk and are well positioned for a shallow recession.

Even if we are wrong and we get a temporary slowdown in the economy, we believe it will be shallow since the banking system is in such good shape.  Bank stock could perform very well in a shallow recession similar to the 2001-2002 recession.

We believe if you are bullish on the economy, the best way to express your view is researching and buying a few of these Financials stocks.  Of course, we’re happy to do the investing for you if you’d like to invest in one of our investment portfolios.  Send us an email at derek.pilecki@gatorcapital.com or call us at (813) 282-7870.