XLF: Performance And Valuation Update - June 2019

by: BOOX Research

XLF is up 14% YTD, but essentially flat from Q4 2017 levels, highlighting extreme levels of volatility over the past year.

A more dovish Fed since, coupled with resilient economic growth and strong consumer dynamics, has benefited financials.

MSCI is the best performer in the group, up 53% in 2019, while Citigroup has the highest return among banks, up 28% YTD.

The ongoing yield curve steepening and inversion at the short end signal higher risks for financials.

Renewed concerns over global growth and uncertainty from ongoing trade disputes should pressure sentiment in the near term.

The Financial Select Sector SPDR ETF (NYSE:XLF) tracks the performance of the S&P 500 financial sector stocks. XLF with an inception date in 1998 currently has $23 billion in total assets and has become one of the largest and most liquid sector-specific exchange traded funds. The group of stocks is diverse between sub-industries, including large and small banks, insurance companies, credit services, capital market services, and asset management companies. As a group, financials typically have a higher sensitivity to changes in interest rates and are overall highly pro-cyclical compared to the rest of the market. Year to date, the ETF is up 14%, but has experienced extreme periods of volatility over the past year and essentially flat compared to levels going back to late 2017. This article highlights the performance of XLF components and discusses relevant trends and developments.

XLF Monthly Stock Price Chart. Source: FinViz.com

There is a growing sense in the market that we have entered a late-cycle dynamic, although this point is up for debate and contentious among equity bulls. The thinking goes that economic growth presents a pattern in which periods of expansion are followed by stagnation that eventually ends with a recession. A decade following the financial crisis and into one of the longest bull markets in history, signs are emerging that policy-makers will be challenged to sustain the current momentum. The ongoing yield curve steepening and inversion at the near end based on shorter-term rates higher than the long-term yields is an ominous sign that has in the past signaled a recession. The dynamic implies that, and output gap of activity in the future will lead to deflationary pressures. The scenario has created challenges for financials that have become accustomed to borrowing cheaply and building out longer-duration loan portfolios. The potential for a cyclical downturn in the coming years remains the greatest risk facing all stocks, but particularly those with exposure to the credit cycle.

Holdings Performance Data

XLF holdings performance. Source: Data by YCharts/table author

Despite the rebound in financials this year from the lows of December 2018, 20 out of the 67 equity holdings remain in a "bear market," down 20% or more from their respective 52-week highs. The sector remains volatile with nearly half the stocks falling over 5% over the past month.

Credit services companies have been the best-performing group, benefiting from strong consumer dynamics among better-than-expected economic growth in Q1 and record low levels of unemployment. Credit card delinquencies have trended lower in recent months.

Synchrony Financial Inc. (SYF) is one of the big winners in XLF, up 47% in 2019, although just enough to reverse its large declines from 2018. The stock is flat on a year-over-year basis. The company produces store branded credit cards for retailers earning interest on balances. Curiously the stock continues to trade at a deep discount to the group based on trading multiples. A forward PE of just 7.6x suggests some skepticism in its loan book, considering exposure to consumers and increasing cyclical risks.

MSCI Inc. (MSCI), a financial data provider within capital markets, is up 53.4% YTD as the best performer in XLF. The securities data and analytics provider has had a really impressive run over the past decade. The company calculates over 180,000 indexes worldwide and claims 97 of 100 top asset managers in the world license its products. The global trend towards passive investing has made its indices often time de facto benchmarks in the industry.

YTD, asset managers in the group including State Street Corp. (STT), Affiliated Managers Group Inc. (AMG), and Bank of New York Mellon Corp. (BK) are among worst performers in order down 11.1%, 9.0% and 6.3% each respectively. STT, coincidentally the parent company sponsor of XLF, along with industry peers is going through challenges as fierce competition has driven down fees in the industry. AMG has been weak, in part given its significant levels of exposure to Chinese asset management clients.

Among banks, Citigroup Inc. (C) has the highest return, up 28.3% YTD. An effort at cost cutting and expense reduction has proved effective, with Citigroup reporting steady earnings growth, and it appears to be closing the gap on profitability metrics compared to larger peers JPMorgan Chase & Co. (JPM) and Bank of America Corp. (BAC). On the other hand; Wells Fargo & Co. (WFC) has significantly underperformed he sector, up just 1.4% in 2019.

Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) has significantly underperformed financials, down 1.3% year to date through June 4th data. The holding company conglomerate is technically classified as part of the insurance industry, but has direct investments across a number of sectors, including a large portfolio of listed securities. Significant bets on Apple Inc. (NASDAQ:AAPL), Wells Fargo and controlled company Kraft Heinz (KHC), all of which have been volatile recently, at least adding to negative sentiment.

Holdings Valuation Metrics

XLF holdings valuation metrics. Source: Data by YCharts/table author

The table above presents valuation metrics sorted by industry groups. The weighted average PE for XLF over the trailing 12 months is 14.9x while my data shows the forward PE is 13.7x.

Citizens Financial Group Inc. (CFG) screens well with the lowest price-to-book among banks at 0.8x and debt to equity at 0.5. The First Republic Bank (FRC) appears richly priced with a PE of 18.6x, price-to-sales 5.3x, and price-to-book of 2.0x. The market appears to be assigning growth premium as the company reported a 12.2X rise in revenues last quarter and 11.5% increase in EPS year over year.

The table below shows average dividend yield among the holdings by industry from the data above:

XLF average dividend yields. Source: Data by YCharts/table author

Invesco Ltd. (IVZ) is something of a high yield in the ETF with a dividend yield at 5.9%. The company has made aggressive bets on Asia and has high relative exposure to China. The company reported revenues in Q1 falling 10.4% year over year.


XLF Key States. Source: State Street Advisors

I use the data above as a starting point for further research and due diligence. XLF allows investors to take a strategic or tactical exposure to financials by isolating sector performance from the broader market. I like to think of this fund as a good indicator of the market's perception on the health of the economy and credit conditions. Weakness in financials going forward should signal an underlying deterioration of the economic outlook. I'm looking at the $25 level in XLF as near-term support, while a break above $29 resistance implies more bullish sentiment.

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.