Deregulation and the Bull Case for Investing in Financials

Further deregulation of the financial industry is being considered by Congress. What impact will this have on banks?

We expect the main impact of the deregulation measures under consideration will be to lower operating costs for the banks. We believe industry consolidation could accelerate for banks in the $50 billion to $250 billion range of total assets as the combined company will no longer be subject to the highest tier of regulation and reporting requirements.

We do not generally favor a sweeping rollback of regulations that might lead, for example, to significantly lower capital ratios or significantly reduced loan underwriting standards. We believe loosening such regulations could potentially raise industry risk and lead to lower stock valuations.

Higher rates not only benefit lending margins—we believe they also improve the banking sector’s competitive position. Years of low interest rates have allowed nonbank lenders to compete more effectively with the banks. However, with higher rates, bank deposits are once again substantially less expensive than wholesale funding, giving banks a cost advantage relative to other non-bank lenders—one they have not enjoyed since the start of the financial crisis.

Importantly, we believe banking regulations help keep the competition at bay. Non-banks seeking to enter the financial services industry cannot offer insured deposits—the key to a bank’s long-term franchise value—to their customers without operating under the Federal Reserve’s regulatory umbrella. Historically, few non-banks or other companies have ever wanted to take this step, effectively discouraging new entrants into the banking industry.

The Fed continues to signal a steady rise in the federal funds rate. How are rising short-term rates affecting bank profitability?

Rising rates are helping to increase bank profitability as interest rates on loans are moving higher more quickly than banks’ cost of funds. Higher short-term rates are also improving the value of deposit franchises as the cost of wholesale funding—the alternative for institutions with no deposit base—is now well above the cost of deposits. Additionally, we believe the low relative cost of deposits will help drive acquisition activity, as institutions can lower their cost of funds by buying banks with attractive deposit bases.

Can you describe the different kinds of companies that compose the Large Cap Financial Fund? What is driving performance for each type?

We can divide the Large Cap Financial Fund into three groups:

1.The largest group is fee-based electronic service providers, whose growth is being driven by the global shift towards cashless forms of payment. These include companies such as Visa, Square, and Paypal.

2. The second largest group is large banks, such as JPMorgan Chase and Citigroup, whose growth is being driven by margin expansion as a result of higher rates and the reduction of noninterest expenses.

3. The smallest group is mid-sized banks, such as Zions Bancorp and Citizens Financial Group whose growth is being driven to a degree by margin expansion and cost reduction programs. We anticipate that stock prices of mid-sized banks will continue to benefit from increased acquisition activity as well.

What is your investment case for financial companies today?

In our opinion, the bull case for investing in financials rests on three main pillars:

First, there is the growth of the fee-based electronic service providers. Companies such as Visa, Square, and PayPal are transforming the payments system worldwide, and we believe they have some of the most robust business models and, correspondingly, some of the best outlooks for growth in the market.

Second, many large banks have elevated expenses from operating costly branch networks with too many employees. The banks are also behind where they should be in implementing technology that can help them become more efficient and improve
customer service levels. Management teams are now recognizing that they have a huge opportunity over the next decade to increase efficiency, lower costs and drive earnings growth, regardless of the rate of loan growth or level of interest rates.

Finally, banks are changing the way they do business, constructing their balance sheets with less risk and moving to increase their fee-based businesses. As banks lower their interest-rate and credit sensitivity, their earnings quality and stability are improving, which we believe will eventually be reflected in higher valuations.