Over the past two weeks, bank stocks have outperformed as a string of better-than-expected earnings releases sparked a significant rally. JPMorgan (JPM) and Bank of America (BAC) beat expectationsand the the entire banking sector has mobilized when their outputs are out. The highlight of the third quarter for banks was Bank of America’s net interest income, which rose 24% despite continued inverted yield curve observed during the period.
Many people were surprised to see the banks showing relative strength last week. It is well known that inverted yield curves are not good for banks. They borrow at the short end of the yield curve and lend at the long end, so long-term interest rates being lower than short-term rates should squeeze their margins.
One of the reasons banks are beating expectations is that the yield curve is not as “inverted” as many think. The curve that is currently inverted is the 2-year/10-year treasury yield spread, which is the 10-year yield minus the 2-year yield over time. This has been reversed by 28 basis points at the time of this writing and has been reversed for most of the year. The true yield curve– the one with the maturities on the abscissa and the yield on the ordinate – always has an upward slope. Very short-term bonds have lower yields than long-term bonds; the inversion starts at the end of one year.
Given that interest rates are rising and the yield curve is not just inverted, it’s a good environment for lenders. High interest rates in themselves are good for banks because they allow them to charge higher interest rates. It is only when the yield curve inverts that this ceases to be the case, and today’s yield curve is only partially inverted.
How to play well in this increasingly bullish environment for banks?
You can try to find banks that you think are better positioned than their peers – I happen to like Bank of America and TD Bank (TD) personally. However, you can just ignore all that and buy the Vanguard Financials ETF (NYSEARC:VFH), giving you visibility into all the major banks, credit card companies, and Berkshire Hathaway (BRK.B).
I bought VFH this year knowing that I wanted more exposure to US financials. I’ve seen bank stocks go down as their interest income goes up. Their incomes were declining, but that was largely due to increase in provisions for credit losses (“PCL”), which is more of a precaution than a real loss. If current recession risks are overstated, banks may lower these PCLs later. I happen to believe that is the case. Media scare stories have trained people to equate “recession” with “catastrophe”. This leads to binary thinking that there can only be rampant expansion or impending apocalypse. In reality, there is a “slight contraction”, and we are in one today: jobs are being addedunemployment is low and retail sales are stable. If we are in fact in a recession, it is a mild recession, not a 2008-style meltdown. For this reason, banks are still well positioned to outperform relatively low investor expectations. VFH is a great way to gain exposure to this undervalued sector, especially for investors who don’t have the time or risk tolerance to nurture individual bank positions.
Why VFH is a Great Alternative to Individual Bank Stocks
There are many reasons why a person would prefer a sector fund to a collection of individual stocks. Diversification is the main reason, the lack of expertise in the sector is another. Any investor can benefit from diversifying their portfolio, most investors would benefit from diversifying the portion of their portfolio invested in financials. Indeed, financial stocks, especially banking stocks, are notoriously different from other stocks, especially in the way they are analysed. If you don’t have any particular expertise in banking, you might want to skip picking individual bank stocks.
First, banks are analyzed using a multitude of ratios that do not apply to other types of businesses. Equity ratios, for example. To start, you have the risk-based capital ratio, which is capital over risk-weighted assets. Then you have other ratios that break down capital into different levels of quality, like the CET1 ratio and the Tier 1 ratio. Finally, there are loss absorption targets, stress tests, and other miscellaneous things. related to capital ratios. The regulations regarding bank capital ratios are quite complex and you need to know them all to understand how risky a bank is.
Second, banks interact with macro factors in a rather unusual way. Mainly, they react to interest rates differently than other companies. Higher interest rates reduce the present value of future earnings of growing businesses and increase spending by capital-intensive businesses like utilities. Banks are unique in that they can potentially profit from rising interest rates. Provided that rates rise in parallel across the entire yield curve and that the curve remains upward sloping, banks generally profit from interest rate increases. However, if the yield curve inverts, this might not happen. In the third quarter, US bank interest income rose, which is consistent with the theory that banks benefit from high interest rates. However, this was not consistent with the theory that an inverted yield curve diminishes banks’ earnings from high interest rates. In the end, I think that the good performance of the banks in Q3 is explained by the fact that the yield curve was not “really” inverted; the 2/10-year spread was negative, but not the shorter maturities”. The thing is, to pick individual bank stocks, you need to know how different banks react to interest rates, because some are much more rate sensitive than others.
Between capital adequacy and interest rate sensitivity, bank stocks have many unique factors that can be a real challenge to understand. In light of this, funds like VFH offer a great way to get started with banking and financial stocks that don’t require deep industry expertise to get started.
First, you get diversified exposure to US banks, including JPMorgan, Bank of America, Citigroup (VS) and Wells Fargo (WFC). Thus, your risk is spread across various banks with varying degrees of capital adequacy and interest rate sensitivity, resulting in a portfolio that can perform well in a variety of different economic conditions.
Second, you get significant exposure to non-bank financial stocks. In addition to banks, you also get holding companies like Berkshire Hathaway, brokers like Charles Schwab (SCHW) and credit card companies like Visa (V). Some of these companies are doing much better than your average bank this year. For example, Charles Schwab is down just 7.3% for the year, while Visa is down only 6.6%. This makes perfect sense, as most major banks have a heavy exposure to investment banking, and i-banking is being hit by the slump in tech IPO underwriting activity. Brokers like Schwab, on the other hand, take advantage of volatility whether the market is bullish or bearish, and capture higher interest income in their lending transactions. Thus, thanks to VFH, you benefit from a strong exposure to non-bank financials, which are doing much better than the large diversified banks this year.
VFH is pretty cheap
Another interesting thing about VFH is that the fund is quite cheap. VFH is not a broad index fund: it is a sector fund that follows MSCI US Financials Index. Nevertheless, it has expenses typical of broad index funds, including:
An MER of 0.10.
Decent tracking (the fund’s net asset value tracks the benchmark only 0.8% accumulated over 18 years).
A bid-ask spread of 0.02%.
These characteristics collectively indicate that VFH is a cheap fund. There is another form of “cheapness” that you can talk about when it comes to VFH: the cheapness of assets. Because financials are out of fashion these days, VFH’s underlying portfolio is pretty cheap, with a P/E ratio of 11.1 and a price-to-book ratio of 1.4. These low multiples are currently available despite VFH boasting an average return on equity of 12.5% and an earnings growth rate of 17.5%. So not only are you not paying a lot for VFH in terms of fees, spreads and tracking error, but you are also not paying too much for the underlying stock.
The bottom line about VFH is that it is an inexpensive fund invested in an industry that is currently out of favor for no particular reason. Sure, bank profits are down this year, but that’s largely due to PCL construction. Many credit card companies and brokers are doing quite well. With VFH, you not only get banks, which could see their profits increase as PCLs shrink in the next economic recovery, but also non-bank financials, which in many cases are already doing quite well.
Certainly, VFH is exposed to many risk factors. Inverted yield curves are not good for banks and recessions tend to increase credit risk. Nonetheless, all signs point to the fact that if we are currently in a recession, it is a mild recession, not a 2008-style meltdown. Taking the pros and cons of financials together, we can safely say that financials are expected to rise in the coming months, much like oil stocks did earlier this year. Personally, I’m quite happy to be overweight banks, both individually and through my position in VFH.