Takeaway from Third Quarter Earnings Calls - Financials
Economic headlines and uncertainty over government regulations have probably fueled an excess amount of pessimism in the financials sector, and it ended up with one of the highest percentages of companies beating the street estimates among all the sectors. The earnings beat rates are measured by dividing the number of companies beating the estimate by the total number of companies reporting in the various sectors. The table below lists the top-10 performers. Lack of analyst coverage for certain obscure players has further created mispricing situations. The Dow Jones U.S. Financials Index initially outperformed the S&P 500 during the earnings season but has since given back all the gain, and now ended flat from a month ago, similarl to the S&P. So this report is not too late in uncovering certain incipient trends, gleaned through the third quarter earnings of top performers in the various segments of financials, and thus highlight potential investment ideas. We will examine four financial segments: domestic banks, global banks, asset managers and insurance companies.
DOW Sector - Financials
Farmers Capital Bank
Knight Capital Group
Mission West Properties
Bank of America
Central Valley Community Bancorp
Among the top-10 performers in beating the street estimates, Republic Bankcorp, Iberia Bank, and Monarch Bank all reported robust year-to-year loan growth despite tighter lending standards. Federal Reserve's QE3, and specifically, the focus on buying mortgage-backed securities, should lower mortgage loan rates and fuel further loan closing and refinancing. In terms of credit quality, Republic Bankcorp and Farmers Capital Bank both reported lower non-performing loan to total loan ratio while Central Valley Community Bankcorp, Iberia Bank, and Monarch Bank all reported lower non-performing assets as a percentage of total assets compared with a year ago. Farmers Capital Bank, Iberia Bank, and Central Valley Community Bank all recorded a lower allowance for loan losses ratio compared with the previous year-end. The net interest margin, while lower than a year ago because of the general low-rate economic environment, remains stable. Thus, there is more potential upside than downside in both the revenue and expense lines of these domestic banks' P&L. There is also a trend for stronger players to take over failed banks at bargain prices from the Federal Deposit Insurance Corporation, which sometimes triggered a significant one-time gain. This should bring additional expense savings and strengthen the overall sector.
Some banks also have a stronger balance sheet compared with a year ago: Republic Bankcorp, Farmers Capital Bank, and Central Valley Community Bankcorp all reported a higher equity ratio vs. total assets compared with a year ago. This provides the backdrop for further dividend resumption or increases.
While we don't have any global banks in the top-10 performers in the above list, I found the indiscriminate pessimism equally prevalent. Global banks are major players in the business of retail and commercial banking, investment banking, and asset management. Some are retreating in one or two areas in order to focus on a core competency while others are moving into new territories as their competitors retreat. The renewed focus and removal of weak players should strengthen the overall sector and improve profit margin. There are incipient positive trends in all of the three businesses.
On the retail side, we are seeing similar things in global banks as in the domestic ones: Deposit balances are up, and banks' balance sheets are stronger, and this has enabled them to finally increase loan production to both individuals and businesses. The Fed's QE3 and attempt to lower mortgage rates has insofar benefited disproportionally the big banks. Since there are now less of them, they should be able to charge a healthy margin despite the overall lower net interest rate margin. Further, the provision for loan losses is declining, providing another boost to earnings.
The headlines on investment banking have been so gloomy, including news of UBS and Barclay retreating from the sector and laying off more bankers. However, both the Fed and the European Central Bank have ensured plenty of liquidity, and this has unleashed bond underwriting and leveraged financing. There might be some pent-up demand for mergers and acquisitions, which are just waiting for clarity on the fiscal cliff and resolutions on Europe.
We have one asset manager among the top-10 performers. As the market has noticed, asset managers have had a good year. Asset inflows in both equity and fixed income have increased and profit margin has improved. There is also a push for retail customers both domestic and abroad. In private equity as well, performance fees and investment income have far outpaced the previous year. Lower interest rates have made many deals profitable. Risk appetite is up, and several new funds have successfully raised money. However, valuation in this group is far more than in the banks.
Although we don't have any insurer among the top-10 performers, there are at least four insurers that beat the street estimate. Improved investment performances have also benefited this group, aided by a historically below-average claims environment prior to Sandy. Now the big question is the impact of Sandy. My guess is that the claim payments will be a drag on earnings for the next couple of quarters, but over the medium term, Sandy will be a positive for the industry as demand for property and casualty insurance increases, the companies will have more pricing power.