The Stock Sector I Like Best (Right Now)
With plenty of cash on-hand, I’m always on the lookout to add to my existing stock positions… or find new stocks in which to invest. Generally speaking though, I don’t consider myself a “sector” style investor. I don’t buy sector ETF’s or sector index funds… but sometimes the market will put entire sectors on-sale.
It happens because investors take-on a kind of “group think” around certain industries. This lemming-like behavior can sometimes be completely right… and those sectors should be avoided.
The future is a funny thing though. Sometimes the future doesn’t turn-out the way we think it will. Nobody could have predicted COVID-19 was going to turn the world upside down in 2020, but it absolutely did.
This is why it pays to look closely at industries out of favor. Some stocks will languish and wither, while others will continue to grow and prosper during a bad economic environment. The secret is to separate out “the baby” from the bath water.
These are the stocks to hunt in downbeat sectors. Some day that sector will return to favor, and owning these down-beaten stocks can pay-off handsomely.
So which sector am I most interested in right now?
Banking. Shares of the banking sector are down a frightening 28%-30% YTD. That’s horrible when compared to the S&P 500’s positive 3.36% for the year (at the time of writing).
Many good banks are actually sitting close to their tangible book value right now. Amazingly cheap!
So what’s the problem with banks?
What’s Wrong With Banks?
Banks have been with us almost since the very invention of money, but the banking industry is challenged right now. Bank stocks are in the dumpster. It happens almost every recession, but COVID-19 has created something of a perfect storm for the banking sector. Investors dislike banks right now for a few very good reasons…
Interest Rates
When the pandemic hit earlier this year, the U.S. Federal Reserve lowered the fed fund interest rate to almost zero (0.09% to give you the exact figure).
This means banks can borrow from one another for almost nothing. Almost free money! Woohoo! Right?
Wrong! Money is a commodity, and the price of that commodity just went to zero. Or almost zero. This means savers are now getting almost nothing for their deposits, and home loan interest rates are near all-time lows.
How exactly does this hurt banks you ask?
Well, pretend you want to buy a home. Let’s say you go to the bank and get a mortgage at 2.5%. The bank loans you its deposits (which pay 0.5% to savers) for the mortgage, and then profits from the difference between those two interest rates. In this case, 2.5% – 0.5% = 2.00%.
This difference between those two interest rates is called the interest rate spread.
This made-up example isn’t far off the mark either — Last quarter JP Morgan Chase (Symbol: JPM) reported a interest rate spread of 1.9%.
With so much “free money” flowing around the economy right now, most investors rightly believe that bank margins are set to be squeezed, and profitability will suffer. Intense competition is going to push down that interest rate spread and hurt bank profitability.
More Loan Defaults
Tough economic times mean high unemployment. People out-of-work during a recession will have a tough time paying the bills. Banks suffer when people stop paying their mortgages, car loans, and credit card bills.
Depending on the terms of the loan, banks could repossess the property, but they will almost certainly lose money when a borrower defaults. Some loans are also “unsecured”, which means banks have nothing to repossess in the event of a borrower default.
Defaults usually mean big losses for banks!
To cover the cost of these failed loans, banks are required to create a “reserve” for loans in doubt. Big banks like Citigroup, Bank Of America, and J.P. Morgan Chase have been reserving billions of dollars in recent quarters to cover those potential losses. Because of this, profits at those banks are WAY down from where they were a year ago.
The Negatives Might Not Be A Big Deal
While the negatives I discussed above are very real factors, that doesn’t mean every last bank on the planet is going suffer.
Surprisingly, the housing market is actually doing really well (despite the pandemic). Low interest rates are spurring home-buyers to buy, and existing owners to refinance. As a result, home prices are up… WAY UP! My buddy Dave over at AccidentalFIRE found that home prices are up 8.5% since last year.
All this is good news for banks, which will need to originate even bigger loans for customers. This may end-up offsetting most of the decline in interest rate spread.
The banking sector also has a huge number of banks that service unique niches. These banks have different customers, different loan products, and different interest rate spreads than traditional banks.
Take for example, Silicon Valley Bank (Symbol: SIVB), a bank which focuses on lending to technology companies around Silicon Valley. When tech companies like Twitter need a loan, they call Silicon Valley Bank. Tech companies are doing surprisingly well right now, so it stands to reason SIVB’s loans are less likely to default than other lenders.
Other specialty banks focus on credit cards — like American Express (Symbol: AXP), Synchrony Financial (Symbol: SYF), Capital One (Symbol: COF), and Discover Financial (Symbol: DFS). Yes, these are banks, even though they don’t operate branches or originate mortgages.
Standard mortgages have seen declining spreads in recent decades, but credit card rate spreads have stayed surprisingly stable!
Another niche to consider is the high-net worth banking niche — First Republic Bank (Symbol: FRC) and Signature Bank (Symbol: SBNY) are two names that come to mind when I think of high-net worth banking. When the filthy rich need a loan, it’s these banks that fill the need. Wealthy clients may also be less likely to default than lower-net worth individuals. High-net worth banks might see comparatively fewer losses because of this wealthier clientele.
Online-banks also seem to be prospering under COVID-19. These banks have no branches, no tellers, no money vaults, and no public facing buildings to maintain. They’re completely “online” from the perspective of the customer. Online banks like Ally Financial (Symbol: ALLY) or Axos Financial (Symbol: AX) have a big advantage over traditional banks because they maintain a lower efficiency ratio than traditional banks.
And that’s a good thing! (A lower efficiency ratio means the bank is actually more efficient)
Final Thoughts
Not all banks are create equal, so why should investors paint them all with the exact same brush? They absolutely shouldn’t!
I believe the market is throwing out several “babies” with the banking bathwater here. Some very good banks are surprisingly cheap right now!
While there are valid concerns around low interest rates and higher loan defaults, these concerns could turn out to be entirely overblown if the economy continues to improve.
Yes, the consensus thinking around banks isn’t very upbeat right now, but that’s precisely why I’m interested in this sector. Down-beaten sectors can make for very good buying opportunities if you have the willpower to invest in the opposite direction of the crowd.
Good luck investing!
[Image Credit: Flickr1, Flickr2 ]
Interesting take, Mr. Tako! I agree with you and I think your analysis is spot on.
I do have some long LEAPs on JPM and AXP. And I also have SQ common stock. Square isn’t really a bank, but it might be a disrupter of traditional banking in the future.
Interesting idea, I’ll have to take a look at Square again.
Being a contrarian is always a good strategy! It doesn’t always work out, but certainly enough to make it worth your while. There was good money to be made ~ a decade ago in banks – it didn’t seem it at the time, which is exactly your point. Good luck to you as well!
Thanks Paul!
I’m a little confused, if house values are way up then repossessed houses should be worth way more than the loan values. Repossessed houses should be a gold mine for banks, what am I missing? The only time a bank loses is when a loan is underwater, which happens, I thought, only when the housing market had crashed?
Unfortunately when residents of a home know they’re going to be kicked out, they don’t take care of the property. They’ll sell off the appliances, not mow the lawn or do maintenance. Hell, I’ve seen people rip the copper plumbing out of the walls so they could sell it.
All that costs money to rehab, fix, replace, stage and so forth.
I’ll give you one example from my own neighborhood — A repossessed home near me needed a new roof ($15k), painting inside and out ($12k), new appliances ($3k), cleaning ($1k), gardening and tree trimming ($2k). There were also some minor repairs that needed to be done that I’m not aware of too. This means the bank had to put in approximately $33k on top of their own costs (employees, lawyers, etc) to repossess the house and make it sale-able.
That house sat for 3 years before the bank decided the local market had appreciated enough to be worth it. Now, a nice family lives there, and I’m sure they got a decent deal on the home.
That jump for Buffett from Wells to BoA makes me wonder what’s going on in the sector.
I definitely like the idea of growth in the sector for the bigger online banks that seem like they should be less affected by COVID.
BOA got a lot more efficient over the past couple of years. It’s now on par with US Bank and JPM. Meanwhile BAC earns twice the net interest margin of JPM and 50% more than USB.
It’s a better bank for your dollar now.
To play devil’s advocate, the banking sector may not be as attractive as its already a highly mature sector so there aren’t great growth opportunities.
Additionally, what matters most to banks is not the absolute level of interest rates but the shape of the yield curve. Because the yield curve is pretty flat right now, its tough for banks to earn strong margins on their loan book. As a result, ROE’s aren’t that attractive at the moment.
I do agree that the wealth management side of the business looks attractive as well as some of the online banks with lower costs. But even those banks will struggle to grow and struggle to generate strong ROE’s over time.
Totally OK to play devil’s advocate! I agree that the large money center banks may have limited growth opportunities, but if you can buy at tangible book value and ROE’s return to more normal levels of 12%-15%, very little growth is needed for a good return.
Say we have 3% inflation and 1% real growth, that’s a annual return of 16-19%. Good enough for me!
Thank you for sharing your insights with us! I think there will be a crash soon, but I agree certain banks are undervalued right now. Hope we can capitalize on this!
It seems to me that nominal interest rates will be forced up by more than 2% in a few years due to inflation, precisely because there is too much liquidity right now. That said, average weighted maturity may only be around 800 days at the moment for C&I loans, and banks don’t really keep loans any more, but immediately sell them off. Is that part of your reasoning?
I love to see we are on the same wavelength! Great minds think alike! I noticed the banking industry stocks came down ~40% during the Covid Correction. I bought into a banking ETF ‘XLF’ at a hefty discount. Like our Buffett says, “Be Fearful When Others Are Greedy”! Keep up the great work Mr. Tako!
Thanks FLA!
Mr. Tako,
I’m trying to follow you of the thought you’d posted above :” if you can buy at tangible book value and ROE’s return to more normal levels of 12%-15%, very little growth is needed for a good return.
Say we have 3% inflation and 1% real growth, that’s a annual return of 16-19%. Good enough for me!”
So you are looking at the Book Value of a bank and compare that to ROE (where do you get this number, by the way?). As a result that now the price (stock) is at a Book value level and ROE is higher, that difference is your appreciation potential?
How do you come up with the 16-19% returns?
Thank you
Canadian banks have a oligopoly in Canada and you can get exposure to the US with either TD or BMO. Both pay a pretty safe dividend above 4% as well. I was making good on BMO and am now into cheaper (IMO) TD.
They all trade on NTSE as well as the TSE.
D