Financials are generally the cheapest sector of the present market, based both on relative measures of P/E and free cash flow and on a comparison to much of their own history. Banks and insurance companies with long and solid operating histories are the cheapest. Why should this be? Is it based upon legitimate concerns?
At work with the pricing of banks is a simple bit of behavioral economics - recency bias. Between 2007 and 2009 reckless behavior by large banks almost blew up the financial world. Several went under, and others had to be merged into healthier peers. Many investors panicked and lost money in the financials they owned and everything else too.
I have a little catch phrase I use with investing friends and family when talking about a stock or sector which stays unaccountably cheap. "The market is mad at them," I say. For the past 8 years the market has been mad at the banks. They have been a hold-your-nose investment. Is this a legitimate note of caution or a long-term opportunity?
Because of the 2009 debacle banks have had their wings clipped. They operate with their actions and their balance sheets under close scrutiny. Careful limits are placed upon their operating actions and return of capital. The real question is whether these constraints have impaired their position.
The really large question is to assess the risks hanging over banks that make some of the best of them sell around 12 times earnings. The upside could be great. If banks are actually pretty safe and have any growth prospect at all over, say, the next decade, they are a very cheap investment.
Let me then look at what I believe to be the three concerns about banks and attempt to attach a number to their relative importance. They are, in descending order, (1) a flattish yield curve which tends to compress Net Interest Margin (NIM), the key measure for healthy banks, (2) regulatory risks, and (3) the risks of competition from new models of lending which might attack the business model of banks.
(1) The flattish yield curve and shrinking net interest margin.
Low interest rates and a flattish yield curve are lingering after-effects of the financial crisis, produced by a large debt overhang and cautious consumers. The Federal Reserve has played a role in its effort to prop up markets, but I am agnostic on the question of whether the Fed defines the level of interest rates or largely follows markets.
Whichever is the case, unusually low long rates going out more than ten makes for a difficult operating environment for banks and insurance companies. Insurance companies struggle to find safe return to offset future liabilities. Banks struggle to make loans at a high enough rate to maintain a reasonable NIM. One interesting aspect of this problem is that the strongest insurance companies tend to do better by good underwriting and self-cannibalization (investing in buying back their own shares) and the strongest banks do better than average by having a mix of revenue sources as well as buying back shares.
I have no opinion on when the slope of the yield curve might steepen. It might acquire a more upward slope if the economy reaccelerates and inflation kicks in a bit. On the other hand, it may require a final clearing recession to liquidate more debt and provide consumers with cleaner balance sheets. It is impossible to calculate the timing of yield curve steepening (or Fed rate increases), and it is basically not worth trying. The reasonable thing to do is to buy banks and insurance companies that will continue to do well under the current flattish yield curve and will do much better when the yield curve steepens.
My favorite insurance companies are property and casualty stalwarts Chubb (NYSE:CB) and Traveler's (NYSE:TRV). I own both in size, but they have done well enough lately that I would probably wait for a dip to add. My favorite bank is - well, let me save that for the conclusion.
The flat yield curve and shrinking net interest margins probably account for about 65% of the cheapness of bank stocks - making it the predominant reason banks are selling so cheap.
(2) The overhang of regulatory risk.
I noted this morning that the Republican Platform contains a commitment to restore Glass-Steagall, the sharp separation of retail and investment banking which was in effect from the Great Depression until the Bill Clinton Presidency. At present, the notion of restoring Glass-Steagall is a measure of how much banks are broadly hated. It's also a desire to firmly close the barn door with the horse already out of the barn.
It won't happen. The net positives of the hybrid bank structure outweigh the negatives, and banks like JPMorgan (NYSE:JPM) will maintain their present hybrid structure. That doesn't mean JPM is my favorite bank, although there is probably nothing wrong with it as an investment. I'm just drawn to the purer, safer bank model of acquiring funds cheaply and lending them out at a predictable profit.
We do live in an environment in which banks that make missteps are going to be picked on. Even Wells Fargo (NYSE:WFC) has been taken to task for lending practices, and regulators find it easy in the current climate to virtually extort quick and costly settlements. The positive part is that settlements for alleged bank misdeeds are small in the larger picture, and growing smaller.
The poster child of a regulator-afflicted bank is Bank of America (NYSE:BAC). One way or another Bank of America had its hands in pretty much everything that blew up in 2009, was unlucky in having bad peers crammed down on it, and couldn't seem to get anything right with regulators, in part because of botched preparations for capital assessment. It has, however, survived. You could make a case that it has the best prospect for higher dividends and large gains as the bad climate for banks recedes.
And the bad climate is indeed receding. The exact moment when a tide stops coming in and begins to recede is obscured by individual waves. The regulatory tide, however, seems to be slowly receding, and closely supervised banks appear stronger than ever before. Buffett has commented on their current solid balance sheets in several places.
I attribute about 25% of the cheapness of bank shares to the overhang of supervision and regulation, but it is the risk most likely to disappear in an orderly and predictable fashion. If you buy or own a bank, it should be the least of your worries - an opportunity not a risk.
(3) Alternatives to traditional banking.
This is a risk I have kept in the back of my mind for a couple of years. The market doesn't generally care much about fat tail risks to a business model (getting Amazoned, for instance, like book stores and traditional brick and mortar retail) until they suddenly loom large, but they are worth doing a brief assessment.
It's hard to assess what pressures fintech/crowd sourcing will have on traditional banks. My gut feel is not too much for quite a while, if ever. However, I watch them out of the corner of my eyes. Meanwhile, several such alternative models have come a cropper, and for predictable reasons - mainly absence of the risks controls banks generally employ.
To succeed in competing with traditional banks (or insurance companies) involves developing efficient management of risks, attracting the right mix of business and staying on the right side of regulation, which is certain to follow any major success. To make a long story short, an entity which hopes to compete with a traditional bank has to ultimately look pretty much like - well, a traditional bank.
New competitors, as in any other industry, deserve the occasional glance out of the corner of your eyes. I think the threat assessed by the market is perhaps a 10% contribution to the cheapness of banks. I'm not very worried about it.
So I Added To Wells Fargo
My overall assessment of the banks is that they are cheap relative to the market as a whole and to their own history. I have looked at regionals because they operate on a plain vanilla banking model. During the Brexit dip I dropped a limit order on Washington Trust (NASDAQ:WASH) - a bank analyzed and recommended by Ian Bezek. My limit order missed the low price by a dime - too bad.
I own a moderate position in U.S. Bank, of which I am also a customer. I recently got a lesson in how they are making money under these conditions. Going in to get new checks, I was ushered into an office for a world from the mountaintop view of all the things the bank would like to do for a customer like me who keeps a large balance. I politely declined the credit cards, etc. Then a few weeks later a tennis customer bounced a check and U.S. Bancorp (NYSE:USB) - my own bank - charged me 19 bucks. Wow! My tennis customer reimbursed me, but I got the picture. Banks have stepped up the process of nickling and diming their way to earnings.
My favorite bank holding is Wells Fargo, which resembles the local and regional banking model more than other majors but includes all the advantages of national scale. I bought more of it recently on the 3% dip following "disappointing earnings." Quarterly earnings "disappointments" bother me only when reflecting a basic long-term deterioration, and I was unable to find any such thing in the WFC call. The 3% drop brought WFC within a few points of recent lows with a P/E just under 12 and a dividend yield above 3%. I saw no very coherent reason for the one-day fall in price. I added just under 20% to family holdings, enough to lift it into second place among household holdings.
Here's the real way to think about WFC earnings, as well as those of many other banks. Yes, growth is slow and subject to the occasional hiccup. On the other hand, net interest margins have been awful, and yet WFC - which doesn't have an investment banking kicker - still made good money. The key thing at WFC is the steady profit margin in mortgages, and my personal assessment is that housing will do reasonably well with improving growth over the next few years. Maybe there will be one recessionary hiccup. WFC is also famously effective with cross-selling and deriving income from services. With the solid earnings and slowly growing dividend, plus buybacks, I'm comfortable with it.
Disclosure: I am/we are long WFC, TRV, CB, USB.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.