The financial sector has been a lagging the S&P 500 (.SPX) this year. But pessimism regarding the sector is now so running deep that it may have created a good buying opportunity.
According to Goldman Sachs, financials are the most undervalued sector in the S&P 500. Implied relative earnings-per-share growth for the sector averaged 4.2 percentage points below the S&P 500 over the past 10 years. But implied five-year earnings growth is now 8.1 points below the market. That’s the lowest implied growth of any sector in the S&P 500, and it is far below others, according to Goldman’s U.S. Quarterly Chartbook released on Monday.
Financials look cheap on traditional metrics too. The sector trades at 11.5 times estimated earnings for the next 12 months, lower than any other sector and well below the market’s average P/E of 16.9, according to Goldman. Moreover, financials have the highest expected earnings growth for 2019, with estimated EPS of 8.2%.
Goldman uses a complicated formula to calculate implied earnings growth. The firm starts with a dividend discount model and factors in an equity risk premium, nominal GDP growth, and historical valuations. By those measures, Goldman is assuming a 2%-4% equity risk premium (expected returns over a risk-free rate) and a range of -3% to 9% annualized earnings growth over the next five year, with an average of 5.9%.
These estimates are a snapshot in time, involving assumptions that continually shift and alter expected returns. There’s also a wide dispersion of returns within each sector. Goldman’s research shows that consumer finance companies have delivered the best results in the financials sector this year, averaging 16.8%, more than double the sector’s 8.6% return. Insurance brokers, property-and-casualty companies, and life-and-health insurance firms have also outperformed the broader sector. Diversified banks, brokerages and investment banks have performed about average.
Among large financial companies, Synchrony Financial (SYF) tops the charts for returns this year, according to Goldman, with a 36.9% gain through March 29. MSCI (MSCI) has been another winner, returning 35.3% while Moody’s (MCO) has gained 29.7%.
E*Trade Financial (ETFC) looks like one of the cheapest financial stocks now, with relative implied earnings per share growth of negative 23.1%. Comerica (CMA), Zions Bancorp (ZION), Invesco (IVZ), and Charles Schwab (SCHW) all look cheap on that metric too, according to Goldman.
Banks and other lenders would benefit mightily from a steeper yield curve. The sector has lagged this year as the yield curve has flattened (and inverted lately), reducing banks’ and brokerage firms’ net interest income from lending activity and margins on deposits. A steeper yield curve isn’t something Goldman’s analysts ventured to predict in their report. And it will depend on variables for economic growth, inflation, and the bond market’s outlook.
Assuming all those factors align, banks and other financial firms could do quite well. But that’s a big if, and it is why the sector looks like such a bargain.
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