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.
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.
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.
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.
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.
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.
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.