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State of the sector: financials

Valuations remain attractively low on a price-to-book-value basis vs. the S&P 500.

  • Financials Sector
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Business conditions in the financial sector have continued to improve from the trough levels reached in 2009, though the sector still faces some macro challenges.

For banks, loan growth remains limited, competition continues to put pressure on loan yields, and net interest margin (NIM) compression continues. Mortgage businesses have been healthy but activity has slowed recently with the recent rise in rates, and credit trends continue to improve. In the capital markets industry, merger and acquisition activity remains subdued. Conditions in Europe have stabilized, and global macro risks have diminished to some extent.

Revenue growth

Looking more closely at the most recent financial results, corporate sales (revenue) growth in the financial sector was 6.6% in the first quarter (Q1) of 2013 on a year-over-year basis, which surpassed analysts’ expectations (3.1%) and was significantly better than the revenue growth for the overall U.S. equity market (0.6%).

Among specific industries, mortgage finance companies exhibited the strongest revenue growth within the sector (19.7%), benefiting from an emerging recovery in the U.S. housing market. The consumer finance industry also delivered solid revenue growth (12%) due to the improving profile of the U.S. consumer (e.g., rising home prices, declining unemployment, improving consumer sentiment, and growing real income). Stable pricing on insurance premiums and an increase in the 10-year Treasury yield helped the insurance industry achieve a 10.1% rate of revenue growth.

Elsewhere, rising rents, stabilizing asset prices, and sustained low interest rates boosted revenues for real estate investment trusts (REITs) by 9.6%. Capital market stocks experienced revenue growth (6.8%) in line with the broader sector. Barring the usual seasonality in the second quarter, trading volumes generally have held up, which should support favorable results when second quarter (Q2) earnings are released.

A couple of industries experienced disappointing revenue growth. In particular, the lingering impact of potential new regulations and limited investment opportunities weighed on revenue growth for diversified financial companies (0.4%). Meanwhile, low interest rates, sluggish loan growth, and heightened competition hindered revenues for commercial banks (0.5%).

These trends largely continued into the second quarter of 2013. In mid-June, however, the Federal Reserve’s (Fed’s) statement indicated the central bank is prepared to begin phasing out its asset purchase program (quantitative easing, or QE) later in 2013 and may stop purchases in mid-2014 as long as the economy stays on track.1 This statement was a shift in tone that caused an uptick in interest rates, induced volatility, and sparked a global reallocation of assets. The economic effects are still to be determined, but in the short term, the Fed’s communication may depress capital markets activity.

Earnings growth

As is typical for financial stocks at this point in the business cycle, earnings in the sector generally have rebounded much more strongly than revenues. This dynamic is largely due to the continued release of loan-loss reserves by banks, which were built up earlier in the cycle. Overall, credit conditions generally have improved. Loss rates (charge-offs) absorbed by banks and other credit providers as a result of loan defaults have fallen below the historical average level over the past 30 years.2 The release of loan-loss reserves, which has provided a boost to earnings in recent quarters, is likely to have less influence on profit growth going forward.

Earnings growth in the sector (15.2%) was well above analysts’ expectations (6.6%) during the first quarter, and well above the 3.8% aggregate earnings growth rate of the S&P 500 (see Earnings Scorecard and the chart right). Leading the sector’s profit improvement were diversified financials (37.5%) and commercial banks (26.3%), which benefitted mainly from restructuring/cost savings programs and lower credit losses—even with limited topline growth. The U.S. housing recovery, improving credit profiles, and double-digit revenue growth drove strong earnings growth for mortgage finance companies (20.5%).

Companies operating in the capital markets experienced modest earnings growth (4.3%), again driven primarily by expense management. Earnings growth declined in the consumer finance industry (–11.9%), as the benefit of loan-loss-reserve releases for this group began to wane.

Overall, strong corporate balance sheets have continued to provide a solid foundation for the financial sector. As of the first quarter of 2013, banks on average had a historically high (equity+reserve)/asset ratio of 12.38%, which has remained above the 11.15% average level since the financial crisis in the fourth quarter of 2008 (see the chart right). This balance sheet strength among banks has resulted in broadening dividend approval from the Fed.

Meanwhile, REITs have continued raising capital to fund expansion, and the industry’s overall leverage (debt) is near its lowest level during the past decade. Going forward, balance sheets in the sector should remain strong, and companies are likely to be more focused on revenue and market share growth as the interest rate headwind stabilizes and investment opportunities improve.

Assessing financial stock valuations

Valuations among financial stocks generally remain attractive. The sector is trading at a multiple of 0.49 on price-to-book value (Rel P/BV) relative to the S&P 500 Index, which is well below the group’s long-term average since 1994 (see the chart below, right). Commercial bank stocks have been inexpensive relative to their historical average valuations, trading at a relative multiple of 0.53 on Rel P/BV due to limited growth opportunities and the industry’s uncertain regulatory backdrop. Insurance stocks have also been inexpensive, trading at a multiple of 0.43 on Rel P/BV.

Elsewhere, the valuations of consumer finance stocks generally have been among the highest in the sector due primarily to significant top-line growth since the trough levels in 2009. REITs are the most expensive segment within sector based on Rel P/BV, but have the highest dividend yields, and thus often have been viewed by investors as an attractive source of yield in a climate of historically low investment-grade bond yields. REITs have also been viewed as a relative safe haven among financial stocks by some investors still concerned about the health of the overall financial sector, post the global financial crisis.

Outlook on financial stocks

The prospects for the financial sector are more promising than they have been during the past couple of years. On the positive side, balance sheets have been repaired, costs are being rationalized, and housing, which represents a key underlying driver, is in a sustained upturn. The recent rise in medium- and long-term interest rates—if sustained—should mitigate some of the net interest margin pressure that has afflicted banks and insurance companies during the past few years. Finally, valuations remain attractive and the potential for accelerating capital returns appears promising.

Offsetting these factors is a lingering uncertainty over regulatory changes to certain financial industries—some of which are yet to be finalized, leaving the ultimate impact to profitability unknown. In addition, the ongoing tepid U.S. economic recovery, the uncertain effects from the Fed’s eventual curtailment of its quantitative easing program, and the still tenuous situation in Europe continue to warrant monitoring. In the near term, the increased volatility across various asset classes also bears watching; while it may benefit certain companies tied to the capital markets, it also introduces potentially unwanted influences on bank balance sheets.

Ultimately, the current environment suggests there is likely to be ongoing stock performance differentiation within the financial sector, which is an attractive opportunity for active portfolio managers who rely on extensive research to identify the most promising stocks.

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Quantitative easing (QE): Unconventional monetary policy used by central banks to stimulate the economy. Typically involves the purchase of financial assets from commercial banks or private institutions, which increases the monetary base.
Equity/assets ratio: A financial metric used to ascertain a company’s financial stability. The equity-to assets ratio is the value of the corporation’s equity divided by the value of its assets. Equity represents the total current value of the money invested in the corporation by all its shareholders— the cumulative value of all its shares—in addition to any retained earnings generated by its operations. Assets represent the entire value of the corporation, such as its equity, its inventory, its accounts receivable, and any revenue generated from loans. A high ratio means that the corporation is mostly owned by its shareholders, while a low ratio means that the corporation is likely burdened with high debt.
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1. FOMC press conference statement, Ben Bernanke, June 19, 2013.
2. Among FDIC-insured institutions, the net charge-off rate of total loans and leases declined to 0.83% as of Q1 2013, down from a peak of 3% in Q4 2009 and below the historical average of 0.95% since 1984.
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