While investors are in a panic about rising yields on U.S. Treasury notes, there's actually one group that benefits from this trend: regional banks. That makes them an attractive buy right now.
It's about time for some good news for unloved local lenders. They suffered serious damage during the summer. From June 8 through Oct. 1, the SPDR S&P Regional Banking ETF (KRE) fell 9.8%, compared with a 5.2% gain for the S&P 500 Index (.SPX).
Banks got hurt as analysts jumped on the "inverted yield curve" meme. The yield curve — a plot of short-term Treasury yields against long-term yields — was nearly flat at the time. Many analysts thought falling long-term yields would invert the curve. This would hurt banks because they borrow at the short end and lend at the long end of the curve.
But the inverted yield curve forecasts turned out to be baloney. They never made a lot of sense because the tight labor market suggested wage and price inflation would heat up. So long-term yields were bound to move higher on inflation fears, sooner or later.
Now, with 10-year Treasury yields suddenly rocketing higher on signs that wage growth and inflation are indeed heating up, the yield curve has taken an upward slope. This is good news for local banks. You see it in their stocks. Since October 1, the SPDR S&P Regional Banking ETF has been positive to flat, while the S&P 500 fell 5% or more.
I got an inkling that this would play out during September because of all of the buying by bank insiders with good records. On this basis, I suggested five banks on Oct. 3 in my stock newsletter, Brush Up on Stocks. The best performer in the bunch, Century Bancorp (CNBKA) was recently up 12% compared with a 5% decline for the S&P 500. The others are basically flat in a down market.
Bank insiders aren't the only ones who like bank stocks. I recently spoke with five fund managers and analysts who specialize in this space. They offer the following reasons to favor banks, and several of their favorite names to consider.
Growth concerns are overblown
Investors were selling banks on concerns about earnings and loan growth, too. Home sales are softening, and business tax cut windfalls curtailed loan demand growth, points out Dave Ellison, a bank sector expert who manages the Hennessy Large-Cap Financial Fund (HLFNX) and the Hennessy Small-Cap Financial Fund (HSFNX). But he thinks investors are overly worried about banks. He sees room for growth in loan yields and cost cutting. "The issue here is the market is not as patient as it needs to be in this space."
Regional bank business customers are in good shape and this will help banks, agrees Russell Echlov, who helps manage the RMB Mendon Financial Services Fund (RMBKX) and the RMB Mendon Financial Long/Short Fund (RMBFX). "We're still seeing some good job growth and strong production numbers," says Echlov. "We feel good about the sector here. Sentiment has gotten overly negative."
Value may come back into style
Value investing has been out of style. But now with the high-growth FAANG stocks Facebook (FB), Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX) and (GOOGL) rolling over, this may change.
"Typically when this happens, people go into value stocks and more stable stocks," says Ian Lapey, who worked with Marty Whitman at Third Avenue Management for years, and now manages the Gabelli Global Financial Services Fund (GGFSX). "Regional banks are cheap compared to the FAANGS." Lapey prefers banks below tangible book value, but even at 1.5 times book value and 13-15 times earnings on average, regional banks look reasonable, he says."I think the fundamentals are great."
Favorable regulatory environment
Bank regulations peaked after the 2008 financial crisis, but now they are being rolled back, particularly for smaller regional banks, says Lapey. They no longer have to go through stress tests, for example, and many have been exempted from the "Volcker Rule," which restricts certain types of investments.
Strong balance sheets
Anyone who went through the 2008 financial crisis is still at least a little paranoid about banks blowing up. But the risks of that are low, since banks generally have great balance sheets. Fears about blowups probably still suppress bank-stock valuations. But that may change as those fears wane.
Investors have indiscriminately sold off regional banks, believes Thane Bublitz, an analyst who follows banks at Thrivent Mutual Funds. And he thinks that creates opportunities. Here's a quick guide on what to look for, and banks that look like the best buys.
My bank-expert-think-tank definitely favors banks that have "quality" deposits. "As rates go up, the focus is on deposits because the cost of funds might get out of hand," says Ellison. Portfolio managers look for core deposits linked to long-term business and retail relationships, and low-cost money market funds. They avoid pricey deposits gathered through mass marketing efforts on big brokerage platforms.
"Anybody can make loans, but very few banks have a good deposit structure," says Ellison. He thinks banks that fit the bill include Union Bankshares (UBSH) and Independent Bank (INDB), Thrivent's Bublitz cites SVB Financial (SIVB), BOK Financial (BOKF) and Heritage Commerce (HTBK).
Room to grow
Bublitz likes to see a low loan-to-deposit ratio. This means banks have room to grow their loan books, and they might not have to pay too much for deposits. On this basis, he favors SVB Financial, Heritage Commerce, Zions Bancorp (ZION) and KeyCorp (KEY). They all have loan-to-deposit ratios comfortably below the 95% level that's typical at regional banks.
RMB Mendon's Echlov likes banks that aren't fully loaded up on commercial real estate loans, as long as they're in strong markets for those loans. Again, this means room to grow. Here, he favors FB Financial (FBK). It also has a below-average loan-to-deposit ratio.
Banks with proven specialties can be winners. Echlov likes Triumph Bancorp (TBK) for its specialty finance business serving the trucking sector. Ellison, at Hennessy, likes First BanCorp (FBP) of Puerto Rico. It will benefit from the federal money into the island over the next five years as part of the hurricane-rebuilding effort. "They have a decent deposit base and Puerto Rico's economy could be counter cyclical to what may happen here because they have guaranteed federal funding coming in."
Insiders are buying bank stocks
Besides Century Bancorp, I recently suggested Independent Bank Group (IBTX) in my stock letter. The shares of this bank serving Texas and Colorado were recently down 15% since May and trading near 52 week lows. The bank now sells for 1.4 times book, which is relatively cheap. This bank has had to pay up for deposits because of solid loan growth. But the bank is acquiring other banks with lower deposit costs, and this will help.
Rising yield risk
Rising long-term yields definitely help regional banks. But too much of a good thing can hurt. If interest rates go up too much, that will damage the economy and loan demand. Is that a risk?
"I don't think we are anywhere near that tipping point," says Cheryl Pate, a bank debt analyst at Angel Oak Capital Advisors. "We still expect margins to expand in a rising-rate environment."
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