Value In A Richly Valued Market: Financials With A Focus On Banks

by: Connor Gustafson

Financials are not as richly valued as the rest of the market.

Rising interest rates at the end of 2015 through 2016 will increase banks' profit margins.

A healthy economy is positive for financials.

The worst of the fines levied on financials are behind us.

Where's the value? Based on fundamental valuations of key metrics, there is no doubt about the fact that the S&P 500 is richly valued. The market fetches a P/E of around 19 versus a historical mean of 15, the CAPE, or cyclically adjusted P/E, ratio is over 26 versus a more recently accepted average of 21, and forward P/E of 17.5 versus the 10-year average of 13.5 is not much better, meaning no matter which way you slice it, the market trades at higher multiples than its historical averages. This is no surprise at the end of one of the largest bull runs in history, and since early 2009, the market is up a whopping 209% or about 20% annualized. These are incredible gains for those fearless enough to invest amidst a recession or those that did not waver in their long-term investment goals. After a long bull run, a seemingly overvalued market exists, so where does one find value? Financial stocks offer value at a very reasonable price versus the S&P 500 with potential tailwinds that will boost earnings and profit margins - a formula for producing alpha.

The financial sector as a whole is undervalued versus the rest of the market. The Financial Select Sector SPDR ETF (NYSEARCA:XLF) trades at a P/E of 14 and is flat YTD versus moderate gains by the S&P 500. Additionally, the SPDR S&P Bank ETF (NYSEARCA:KBE) trades at a P/E of 15. Overall, so far this year, we have seen a divergence in financial stocks and the rest of the market, and this divergence creates value in financials as the rest of the stock market sees a higher multiple, and financials have not.

Towards the end of 2015, financial stocks will receive tailwinds from rising interest rates that will lead to higher profit margins. The U.S. Federal Reserve has pursued a zero-interest-rate policy since the start of the 2008 credit crisis through the maintenance of zero federal funds rate in order to stimulate the economy. This has resulted in a low interest rate environment for the past six years that equities have grown to love and bonds have grown to loath.

At recent Fed meetings, Janet Yellen has stated that interest rates will begin to rise most likely at the end of 2015 with further rate hikes in 2016. This is a result of a healthier economy materialized through numbers such as unemployment, housing starts, industrial production, and wages. Higher interest rates are positive for financial stocks, particularly banks. The net interest margin is the difference between the loan rate banks charge and the rate at which banks borrow. When rates creep higher, the bank's' net interest margin will increase, as loan rates increase quicker than deposit rates. This is not a novel idea as many traders have attempted to play this thesis over the past few years with little salvation as the Fed has taken its time, but this time, the Fed will hike rates. Rising rates also signals that the Fed is finally pleased with the state of the economy. A healthy economy is traditionally positive for financials, as there is economic stability with assets swelling and a lower default rate. A healthy economy with rising rates will lead to higher profit margins and stability for financials.

In addition to tailwinds from higher interest rates, the headwinds of fines for financial companies should ease over the next few years. Over the past five years, big banks and financial companies have paid record fines levied by the SEC. JPMorgan (NYSE:JPM), for example, was fined over $35 billion from mid-2011 to the end of 2014 for acts related to the credit crisis, promotion and use of mortgaged-backed securities, and other violations. As the credit crisis fades in the rear-view mirror, fines on financial institutions, particularly banks, should decrease in frequency and cost - thus leading to increased earnings.

I identified eight financial companies that will take advantage of the bull case for financials based on low valuation and strong catalysts for stock appreciation, such as increased earnings and higher profit margin based on higher interest rates, a healthy economy, and decreased fines. These companies also offer tremendous downside protection based on price/book valuation. The metric price/book is defined as [(assets-liabilities)/shares outstanding]. The p/b is the value of a company if the company is to be stripped down and sold today. It is a great measure of the value in banks because banks use strict accounting procedures and deal in a cash-heavy business that results in a very accurate representation of a company's value. The following companies followed by their price-to-book ratios are great value in this space:

Large banks:

JPMorgan (JPM) - 1.16

Morgan Stanley (NYSE:MS) - 1.16

Citigroup (NYSE:C) - 0.83

Bank of America (NYSE:BAC) - 0.79

Regional banks:

Hudson City Bancorp (NASDAQ:HCBK) - 1.03

SunTrust Banks (NYSE:STI) - 1.02

Zions Bancorporation (NASDAQ:ZION) - 1.0

Regions Financial (NYSE:RF) - 0.87

Further, the companies JPMorgan, Citigroup, Morgan Stanley, and Zions Bancorporation have substantial cash on their balance sheets in comparison to debt and are highly attractive value plays. For example, JPMorgan has $123.65 per share when you take cash and subtract debt compared to a share price of about $67. Additionally, Morgan Stanley's exposure to wealth management is appealing as it is a strong area of growth in the financial services industry.

The major risks to such an investment is a downturn in the economy overall. Disappointing economic data could delay the Fed's rate hike or even result in more quantitative easing. This would be highly negative for the financial sector, as low rates mean lower profits and a generally weaker economy can result in defaults.

I recommend adding a few of these value names to your portfolio for downward protection on the markets and alpha generation over the next 12-24 months. The combination of tailwinds from higher rates, slacking headwinds from decreased fines, and a low valuation makes financial sector stocks, specifically consumer banks stocks, highly attractive as a value investment.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.