Mind The 'E' - Most Financials Should Not Be Priced Off Near-Term Earnings

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Includes: FNCL, IAK, VFH
by: Reason Investments

Summary

Near-term bank earnings estimates don't adequately reflect credit losses over a full cycle.

Asset manager earnings estimates don't factor in likely fee pressure if record asset price levels are sustained.

Insurers are the only financials segment that looks attractive to us.

We have a modestly negative outlook for the S&P 500 Financials Sector, with projected downside of 7% relative to the rest of the U.S. large-cap cyclical stock universe. This view incorporates negative relative outlooks for banks and asset managers, partially offset by a positive opinion of insurers. Bank stocks (63% of S&P 500 Financials market capitalization) have benefited from investor focus upon rising net interest income with less attention to the likelihood that credits costs eventually will rise from current levels. Asset managers have risen along with global asset prices, but longer term investors need to factor in the fee pressure that is inevitable if such price levels are sustained. The consensus near-term earnings outlook for insurers is consistent with our own projection of mid-cycle earnings, but there appears to be modest upside for the group.

Our preferred vehicles for financial sector exposure are Fidelity MSCI Financials Index ETF (FNCL) and Vanguard Financials ETF (VFH). These ETFs have expense ratios of 8.4 and 10 bp, respectively. The better choice between the two depends upon how frequently you trade. More active traders should utilize VFH given its narrower bid-ask spread. Given our negative outlook for the sector, we would recommend removing these and any other financials focused funds from portfolios, with the exception of those concentrated with insurance holdings. Our favorite vehicle for owning insurance stocks is the iShares U.S. Insurance ETF (IAK). The fund carries a fairly hefty expense ratio of 44 bp, but is the most cost effective way to get market-weighted exposure to large-cap U.S. insurance stocks.

Banks and other Lending Institutions - Negative Outlook

We have a negative relative outlook for the S&P 500 banking segment, with projected downside of 11% relative to the rest of the U.S. large-cap cyclical stock universe. This group includes 28 companies classified by S&P as diversified banks, regional banks, consumer finance, or thrifts and mortgage finance companies. Our estimate of mid-cycle earnings for the banking sector is 15% below consensus levels projected over the next four quarters. Consensus earnings estimates reflect an increasingly favorable net interest margin for many banks coupled with projected credit losses that are well below averages over a full credit cycle. Banks trade at 13.6x consensus earnings over the next four quarters vs. 16.0x the ArcPoint Advisor mid-cycle earnings forecast. We estimate that the justified P/E for the banking sector is ~14.3x, incorporating a financial leverage discount of 30% (consistent with historical experience) to the 20.4x P/E of U.S. large-cap cyclical stocks.

Insurers - Positive Outlook

We have a positive relative outlook for the S&P 500 insurance segment, with projected upside of 13% relative to the rest of the U.S. large-cap cyclical stock universe. This group includes 19 companies classified by S&P as property & casualty insurance, life & health insurance, multi-line insurance, or reinsurance companies. Our estimate of mid-cycle earnings for the insurance sector is in line with consensus levels projected over the next four quarters. Insurers trade at 12.7x consensus earnings over the next four quarters vs. 12.8x the ArcPoint Advisor mid-cycle earnings forecast. We estimate that the justified P/E for the insurance sector is ~14.3x, incorporating a financial leverage discount of 30% (consistent with historical experience) to the 20.4x P/E of U.S. large-cap cyclical stocks.

Asset Managers, Financial Exchanges and Insurance brokers - Negative Outlook

We have a negative relative outlook for the 19 asset managers, financial exchanges and insurance brokers within the S&P 500, with projected downside of 11% for the group relative to the rest of the U.S. large-cap cyclical stock universe. Our estimate of mid-cycle earnings for this segment is 19% below consensus levels projected over the next four quarters. Earnings forecasts for the near term are elevated by record global asset prices driving higher asset management fee income, and the custody banks are benefiting from improving net interest margins.

In aggregate, stocks in this group trade at 18.7x consensus earnings over the next four quarters vs. 23.0x the ArcPoint Advisor mid-cycle earnings forecast. We estimate that the justified P/E for these stocks is roughly equal to the 20.4x P/E of U.S. large-cap cyclical stocks, based upon ArcPoint Advisor estimates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.