Financial ETFs: Why Now Is a Good Time to Buy

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 |  Includes: BAC, C, FAS, JPM, KBE, UYG, VFH, WFC, XLF
by: Austin Lehman

You have to hand it to banks. They have figured out a way to get people to give them money and allow them to hold it for free.

JP Morgan Chase (NYSE:JPM) recently released its earnings (see earnings call transcript here), and the market responded negatively, with banks generally declining in value. There are a significant amount of factors affecting the banking business in a global economy. I believe banks will benefit from a number of these factors.

First, banks’ cost of capital is low as they receive a large portion of their capital from depositors who require marginal interest (and some service costs), similar to many insurance companies who receive money for use for a number of years before being required to pay corresponding claims. To show the advantage banks inherently have, consider a large real estate company, Simon Property Groug (NYSE:SPG) compared to JP Morgan Chase: SPG’s weighted average interest rate on its debt is approximately 6%.

Conversely, on JPM’s 3 largest liabilities, it pays 2.5% on its long term debt, 0% on its federal funds and .4% on its deposits. This allows JPM to invest in opportunities at 5-6% that are not available to SPG. Recently, I analyzed selling my rental property on a land contract. I was not interested at the 4-5% interest I could command. This, however, is an attractive proposition for a bank because of their lower cost of capital.

We can all agree that they did not utilize this competitive advantage over the past few years. To come out ahead, they have to make as wise investing decisions as other successful companies. They do not have to outperform on the revenue side. They just have to be average on revenue, as their costs are lower.

Second, large banks are some of the first companies to find out about inflation and/or deflation and changes in money supply, as they interact with the Federal Reserve the closest of any private companies. Thus, they are able to make intelligent decisions based on being the first to know. Furthermore, much of their revenue is tied to interest rates, which will rise if inflation rises, although not in lockstep. Warren Buffett discussed how during inflationary times, investors should look for companies who can pass on the inflation to their customers. I believe banks will be able to do this, and automatically, as interest rates rise.

Third, a number of the larger banks appear to have been designated “too big to fail” in past crises. These most likely include JPM, Citibank (NYSE:C), Wells Fargo (NYSE:WFC), and Bank of America (NYSE:BAC) (the 4 banks to receive the largest TARP amounts). If this trend continues, which I believe it will, these banks should be priced at a premium because of the reduced risk of total loss. While there is risk of some capital loss and equity dilution during recessions, the risk of total capital loss appears to be unlikely. Nick Gogerty wrote an interesting article making a similar point.

On the other hand, some factors against banks include negative public perceptions recently, an emphasis of governments to make their operations smaller, and recent mortgage foreclosure failings.

Over the past three to five years, banks have underperformed the overall market. This may be an opportunity to buy low.

Sector Name

5-Day

YTD

1-Month

3-Month

1-Year

3-Year

5-Year

Basic Materials

1.06

6.19

8.79

7.26

27.98

10.53

15.33

Communication Services

0.17

8.26

3.85

7.10

23.90

4.02

9.43

Consumer Cyclical

-1.08

2.87

0.82

1.38

25.78

9.18

6.84

Consumer Defensive

0.99

4.33

3.96

5.70

19.04

2.76

5.88

Energy

-0.98

15.11

5.81

13.91

27.80

2.71

9.12

Financial Services

0.57

6.41

2.56

6.00

5.51

-4.73

-0.31

Healthcare

0.82

7.91

3.51

7.20

12.68

6.41

5.78

Industrials

-1.34

6.43

2.75

4.90

24.40

5.51

6.74

Real Estate

-0.56

6.88

1.72

6.44

15.39

0.74

4.24

Technology

-0.24

5.85

0.94

2.12

21.87

12.35

10.17

Utilities

-0.59

6.84

2.88

7.45

10.26

-1.24

4.70

Click to enlarge

The five Financial ETFs with the largest market cap include XLF, KBE, FAS, UYG, and VFH. FAS and UYG are both leveraged ETFs. While this may make sense for day trading, in periods of high volatility, the returns do not justify the risk involved to buy and hold. This is shown by looking at a history of UCO, a 2x leveraged ETF versus its corresponding unleveraged ETF (PCX). Over the past year, both have approximate 10% returns, again, with UCO having much greater risk.

Of the three remaining financial ETFs, the expense ratios and yields are similar. VFH currently has the highest yield, but again, fairly similar. Richard Shaw’s article was informative. Between the three, XLF is the most weighted to large cap banks. Finally, Tom Lydon’s article was brief but informative for bank investing.

In summary, recent declines related to financial institutions have left them priced attractively. At the very least, it’s time to rebalance your portfolio to re-gain equal weighting to financials. I would argue that it’s time to overweight. Now is a good time to buy, and I expect above average returns over the next five years, in comparison to other sectors. JPM also is attractively priced at a forward P/E of under 10. It’s not free money, but it’s the next best thing, earned money based on wise investing.

Disclosure: I am long VFH, JPM.