Guide to Investing in Financials

Banks, lenders and other financial services firms, a favorite of income seekers because of their reliable dividends, are emerging post-pandemic with strong balance sheets, lots of liquidity and attractive valuations.

While the Federal Reserve sets its sights on even higher interest rates, financials are one sector that could benefit. Banks, in particular, have an opportunity in a rising interest rate environment to expand their revenues, increase their margins, and grow their loan portfolios in a way they have not been able to do for years.

This guide can help you learn about financials, how to invest in the suddenly exciting Financials sector, and why we believe it should be part of your portfolio.

 

What are financials?

The Financials sector is a wide ranging group of industries that offer financial goods or services, including regional and large banks, investment managers, lenders and loan processors, exchanges and insurance. Among the largest companies in this sector are Berkshire Hathaway, JPMorgan Chase, Bank of America, Goldman Sachs and Blackrock.

While some of these are big name, traditionally brick-and-mortar institutions, the Financials sector also includes smaller, fast-growing names in financial technology, or fintech. These companies add innovation to the sector, and they help push the large banks to be more digitally competitive. And because of their big names and operating advantages, large firms are able to compete.

With the rise of cryptocurrency and blockchain, some banks are anticipated to adapt and incorporate cryptocurrency services, digital payments and buy now pay later programs into their business models. Rather than a disruption, innovative financial products have been a boon to the sector overall.

Top reasons to invest in financials

As a portion of an investment portfolio, financials have historically been an attractive long-term holding. The sector has been a steady performer from a historical perspective. As shown in the table below, the Russell 1000® Index Financials has outperformed the S&P 500® Index on a total return basis during this tumultuous 2022 as well as over the past year, three years, five years, and 10 years.

Outperformance of the Sector

Ticker Name YTD 1 yr 3 yr 5 yr 10 yr
RGUSFL Russell 1000 Index Financials -11.22% -13.64% 10.33% 10.49% 13.63%
SPX S&P 500 Index -18.11% -15.19% 9.66% 10.28% 12.76%

Please swipe to view table

A common indicator for the Financials sector, The Russell 1000® Index Financials, has outperformed the S&P 500® Index on a total return basis over a wide range of time and a significantly "frothy" period in 2022.

In 2021, the Financials sector, as measured by the Russell 1000® Index Financials, rose 35% on a total return basis while large-cap banks, as represented by the KBW Bank Index, climbed over 38%, outperforming the S&P 500® Index and even the Technology sector.

In addition, financials generally pay above-average dividends, which help drive shareholder value. As of October 31, 2022, the Russell 1000® Index Financials had a dividend yield of 2.25%, much better than the 1.72% yield of the S&P 500® Index.

Why Financials could be poised for out-performance

Strong corporate balance sheets: Many banks were able to shore up resources during the pandemic, in anticipation of possible bankruptcies or loan defaults. But much of those losses never came to pass, and financial companies generally emerged from the pandemic era with excess capital on their balance sheets, exceptional asset quality and a strong consumer outlook.

Companies seeking capital are able to find it. Consumers used their CARES Act stimulus checks to pay down credit card debt. Bankruptcies are at historic lows. And while higher and rising interest rates could eventually slow mortgages and other lending, housing starts remains relatively strong.

In fact, a slow period of loan growth has created a dramatic mismatch between banks’ loans and deposits. Deposits at the top four banks in America currently exceed their loan balance by almost $4 trillion.

Attractive valuations: Despite their strong positions, banks, lenders and other financial services firms still seem relatively undervalued compared to the overall market - meaning their prices do not reflect the power of their earnings and intrinsic value.

Financials have been trading at discounted valuations compared to the larger market. Based on 2023 estimates, the price-to-earnings (P/E) ratio for the Russell 1000® Index Financials was 12.0x as of October 31, 2022, compared to 16.3x for the S&P 500® Index. Bank valuations in particular are near historical lows, as evidenced by the KBW Bank Index at 8.8x 2023 estimates. The P/E ratio for banks has averaged 13.3x for the past seven years. Even fintech companies, whose stocks tend to trade at a premium because of their potential for growth, have been trading at lower price/earnings due to corrections in the market.

Favorable Price-To-Earnings Ratio & Better Valuations

A lower P/E ratio is generally seen as paying less for a specific equity. As seen here, the KBW Bank Index and the The Russell 1000® Index Financials are theoretically "better deals" than the S&P 500® Index.

Potential for positive earnings: With interest rates on the rise, many financial companies stand to benefit from increased profit margins and more trading activity. In an environment where the Fed Funds Rate is 4.00% and set to rise further, the industry has pricing power that it hasn’t had in nearly 15 years. This could significantly expand their net interest margins, says Dave Ellison, manager of the Hennessy Large Cap Financial Fund and the Hennessy Small Cap Financial Fund. “If you think rates are going up and staying up, then banks are a buy,” he says.

Better Profitability at Commercial Banks

Net Interest Margin, a key indicator of a bank's profitability, is finally trending upward this year at US Commercial Banks after two decades of steady declines.

Loan growth, along with margins, asset quality, and expense control, are important factors for increasing profitability, particularly for smaller banks that don’t have revenue opportunities from business lines such as asset management or capital markets.

Additionally, the banking industry is experiencing an exceptional period of asset quality. In 2021, nonperforming assets to total assets were a mere 46 basis points, down from 274 bps in 2009. Aggregate net charge-offs (the amount charged off when a loan becomes uncollectible) to average loans were 24 basis points in 2021, compared to an abysmal 267 basis points in 2009 and 2010. Both of these metrics have continued to improve in 2022, despite such historically impressive levels already.

High Asset Quality at Commercial Banks

Key indicators of risky assets - Non Performing Assets & Net Charge-offs - are all trending downward in the largest industry of Financials, US Commercial Banks.

Benefit of macro trends: There are a few trends that could benefit financials in the near and long term. One is consolidation in the banking industry. There were 215 bank and thrift mergers in 2021, and the trend is likely to continue in the future, despite a slower pace in 2022. Investing in consolidators can offer tremendous value because it can lead to an increase in both earnings and book value.

M&A Statistics for All U.S. Banks & Thrifts

While the total number of M&A acquisitions has trended downward, there was still a significant number of mergers in 2021 and this trend is expected to continue.

Another trend to watch, for investors with a long-term outlook, is the great wealth transfer. Financials stand to benefit from the estimated $73 trillion in wealth that could be transferred from one generation to another within the next 25 years.

In the meantime, behavioral changes that were accelerated by the pandemic led to an increase in the adoption of digital tools, online business models, branch-free banking and cashless services. These innovations not only appeal to consumers, they can help banks lower costs and increase efficiency. Indeed, banks continue to reduce fixed costs by closing unprofitable branches and consolidating their footprint.

Innovation & Lower Costs = Higher Profits

Banks reached "peak branch" in 2011. Since then a trend of consolidating and closing branches has shown itself to be present. This was accelerated by COVID where banks were forced to adopt more online technology and reduce brick and mortar costs. All of this can lead to higher profit margins.

 
 

What to look for when investing in financials

While you could look for financial investments with the greatest total return, a smart long-term strategy is to analyze companies in the sector for important signs of health. We recommend looking for the same qualities our portfolio managers seek in the sector. These include:

  • High-quality management team with a long-term view and experience through market cycles
  • Uncomplicated business model with a low-cost operating structure
  • Conservative lending culture with high-quality deposits
  • Well-capitalized, well-structured balance sheets
  • Sustainable earnings and book value growth opportunities
  • Attractive valuation relative to peers

How to Invest in financials

Individual stocks

One approach to investing in financials is to purchase the stocks of individual companies in the sector. But building a portfolio of stocks can require extensive research into each company you invest in. Given the variety of companies within the Financials sector, it can be tricky to select the one or two investments that will provide the risk-adjusted value of the sector itself.

Mutual funds

That’s why investing in a financial mutual fund may be the better option. Financials sector funds allow investors to hold many different types of financial companies in their portfolios, which helps increase opportunities and reduce the risk that can come with investing in a single stock.

A sector index fund can provide broad exposure to the Financials sector. Or you can opt for investor oversight and find an actively managed sector mutual fund that allows you to invest in a select group of banks and financial services companies.

Active management

In an actively managed mutual fund, experience in the Financials sector can help drive investment decisions to seek financially-related opportunities outside of strict banking while including those companies that management believes will outperform the overall sector.

For example, the Hennessy Large Cap Financial Fund provides an opportunity to invest in a select group of high-quality financial services companies with market capitalizations over $3 billion. Managed by David Ellison for more than 25 years, the fund seeks stocks that offer value, a compelling risk/return profile and/or a catalyst for positive change.

Ellison, the most tenured fund manager in the sector, also manages the Hennessy Small Cap Financial Fund, a concentrated, actively managed portfolio of 25-50 small company stocks in the sector with market capitalizations of less than $3 billion.

By being highly selective in our investment decision-making, these Funds’ portfolios differ from their primary benchmarks. For example, the Hennessy Small Cap Financial Fund has an 89% active share, and the Hennessy Large Cap Financial Fund has a 64% active share, as of 9/30/22.

Bottom line: Investors may want to consider the Financials sector

Financials have shored up their balance sheets and innovated their business models, and they offer reliable growth and dividends over the long term. Even with recent volatility in the market, financials have held up better than the larger market. And trends seem pointed in favor of financials having even greater success.