Financial stocks have struggled in the early months of 2016, with the S&P 500® financials sector down close to 20% from January 1 through early February, before recovering. Going into the year, there had been hope among some investors that the sector might benefit from rising rates. Instead, some investors have grown concerned that bank exposure to the slump in the energy sector or an economic slowdown could slow rate increases and hurt the outlook for the sector.
Chris Lee, manager of Fidelity® Select Financial Services Portfolio (FIDSX), provides his take on what lower rates for longer could mean, and how he is positioning his fund for a potential transition into the late stage of the business cycle.
|Q:||Which segments within financials might be winners and which might be losers if we saw “lower for longer” interest rates?|
Lee: In broad terms, continued prolonged low interest rates might suggest that the economic backdrop is still sluggish, which generally means less of a tailwind for financials. However, the impact will vary widely depending on industry segment. Those that may take the hardest hit are lenders that depend on “spread-based” revenues, which are revenues earned on the difference between what they pay out on deposits and earn on loans. Asset managers with money market funds also will be disappointed because they can’t make money by managing these assets at current ultra-low rates. Conversely, housing-related companies, such as realtors and title companies, stand to benefit as borrowing costs for home buyers remain low, while REITs (real estate investment trusts) would likely continue to gain as investors look for yield.
The sector as a whole is broadly levered to the economic cycle, but encompasses a much wider universe than conventional wisdom might suggest. A lot of people assume all financials are risky simply because they have credit risk. Having gone through the 2008 financial crisis, many investors are understandably worried about potential losses in financial companies from delinquencies or defaults. But, in fact, if you look at the universe, as defined by the MSCI U.S. IMI Financials 25/50 Index, only about half the names have had meaningful exposure to credit risk: banks, some consumer finance names, and some capital-markets-oriented names. The rest of the industries in the index actually have moderate to no credit risk. Fee-based businesses, such as real estate services, financial exchanges, and insurance brokers, for example, don’t have much credit exposure at all. REITs generally have minimal credit risk, and insurance companies have far less than banks. To be successful investing in this sector, I think you have to differentiate among business models and understand their varying degrees of credit risk. You can’t paint the sector with one broad brush.
|Q:||What would be an example of one of your core holdings?|
Lee: U.S. Bancorp (USB) is a name that has been in the fund since I took over. This is a Midwest-based, diversified bank with what I consider to be a great management team that has a history of delivering returns in excess of the industry. The company has generated earnings growth over long periods, benefiting from its diversified revenue mix, with about half its sales coming from lending and the other half from fee-based businesses, including payment processing. Recently, the stock has traded at a small premium to the sector; however, I think it should be trading at a bigger premium.
In a low-interest-rate environment, we haven’t seen much distinction between high- and low-quality banks. All of them have been pressured by lower net interest margins—the difference between what they earn on loans and pay out on deposits. But a high-quality bank like U.S. Bancorp has relationships that depend less on the rate they pay on deposits and more on the range of services they offer their customers. As a result, I think U.S. Bancorp is likely to be better positioned than some of its peers once rates move higher. Its deposit costs likely won’t have to go up as much, so it could capture more of the rate increase. Also, as credit costs rise, I worry less about U.S. Bancorp, given its strong history and culture of disciplined underwriting.
|Q:||Which stock would you highlight as an example of one of your more opportunistic investments?|
Lee: A good example is OneMain Holdings (OMF), formerly Springleaf Holdings, a company that makes subprime installment loans. I invested in Springleaf in the fall of 2013 at its initial public offering. This was not the higher-quality company I typically favor, but it had some competitive advantages in a space that banks had exited. I also thought the stock looked cheap relative to other opportunities in the sector. Lastly, our research showed the consumer was strengthening, and we thought the industry was ripe for consolidation.
When Springleaf’s stock fell in 2014, I added to our stake. The share price later rallied, buoyed by better-than-expected earnings and the sale of some mortgage assets that freed up cash for future acquisitions. Then, in March 2015, Springleaf offered to buy competitor OneMain Financial Holdings from Citigroup, a deal that I thought made a lot of sense in terms of synergies and cost savings. The acquisition was completed in November, and Springleaf renamed itself OneMain Holdings.
OneMain’s stock rose 15% in 2015, pretty impressive given that the sector benchmark was more or less flat over the same period. Heading into the new year, the company gave back all these gains as the market turned more volatile and investors sold off companies with higher levels of debt.
|Q:||Are you worried about the impact that prolonged low energy prices could have on banks, which are a significant component of the financial sector?|
Lee: It’s definitely something I’m monitoring closely. Individual banks have varying degrees of exposure to energy, and researching the differences can present opportunities to both make and save money. Banks’ exposure can be direct, through loans to the industry, or indirect, through second-order effects. One of the best examples of the latter is commercial real estate in Houston, which grew at a very high rate on the premise that a lot of local companies—and the economy itself—would be bolstered by strong oil prices. Instead, oil prices collapsed, energy companies laid off workers, and commercial real estate vacancies increased. That, of course, has an effect on ancillary businesses—restaurants and hotels, for example—which can drive added credit losses in a bank’s loan portfolio.
In evaluating a bank’s credit risk, I want to understand the extent of both its direct and indirect exposure to the energy sector. I also want to know how the bank managed through the previous energy downturn, back in the 1980s. Heading into 2016, the fund has a sizable underweighting in regional banks, partly because I’ve avoided those that, in my opinion, might be too heavily exposed to energy and related spillover effects. I’ve also been concerned that valuations in the segment look expensive, as many of these stocks have benefited from being U.S.-centric. Of course, energy isn’t the only issue for banks. They could also be hurt by lower-for-longer interest rates and a turn in the credit cycle. Fortunately, a lot of the regulatory issues seem to be behind them, and many banks have done a good job cutting costs.
|Q:||What’s your take on more capital-markets-oriented areas?|
Lee: I’m somewhat cautious. In hindsight, 2015 was a pretty good year for investment banking and brokerage companies. Mergers and acquisitions were at record highs, particularly here in the United States. Issuance was very strong, especially on the debt side and, for equities, during the first half of the year. That’s a pretty high bar for what 2016 could shape up to be. I’m pretty disciplined about valuation, which has largely kept me out of online brokers. They often have a lot of leverage to higher interest rates, but I think that upside potential is already being reflected in their stock prices. Over the past year, I reduced our overweighting in the asset management and custody area, which seemed less attractive to me given prospects for increased market volatility, potential regulatory changes, and growing competition within the industry from exchange-traded funds (ETFs) and alternative asset managers such as private-equity funds and hedge funds.
|Q:||Where are you currently finding opportunity?|
Lee: One area is consumer finance, a segment that historically tends to do well in the early or middle stages of an economic cycle. Arguably we’re heading into the later-cycle stages, although no one really knows for sure. But I think the valuations in this segment are reflecting a lot of macroeconomic fears, including concern that the credit cycle could turn. Even if credit losses from delinquencies and defaults start to increase, I think they could remain at relatively benign levels. That’s partly due to the strength of the U.S. consumer, which has vastly improved since the 2008 financial crisis. You can see that in reduced levels of household consumer debt and higher levels of household savings. Another positive for consumers is low oil prices, which translate into savings at the pump.
One of our top consumer finance holdings is Capital One Financial (COF), best known for its credit cards, but which also offers loans and other banking-related services. It’s growing in a lot of areas that banks have vacated. But Capital One has been overly penalized, I think, for its exposure to energy—which is only 1% of its loan book—and to subprime loans. When I compare Capital One with regional banks, which seems reasonable given its mix of businesses, it looks very attractive.
|Q:||What other areas are you finding attractive at this point in the economic cycle?|
Lee: I like companies that are in a good position to take advantage of the U.S. housing recovery, which isn’t as far along as the country’s economic recovery for a variety of reasons. Limited access to credit and tight lending standards have meant many people who would like to buy homes haven’t been able to get mortgage loans. At the same time, behavioral changes have begun to exert influence, as more millennials—those in their 20s and early 30s—opt to share a rental with friends or to move back in with parents. As a result, household formation is down.
Lastly, housing inventory has been constrained. Over the next five years or so, I think some of these factors could reverse as more millennials start families and as lenders ease certain credit requirements. This pent-up demand could benefit a host of companies in the financial services area, including real estate services providers, title insurers, and mortgage lenders.
Another area that I think offers opportunity—and is not included in the sector benchmark—is the data processing and outsourced services segment, or what I consider to be financial technology. This would include companies such as card payment processors Visa (V) and Mastercard (MA), two high-quality, competitively advantaged companies that I view as core portfolio positions. Both have well-known brands, wide global reach, difficult-to-replicate networks, and tremendous scale from the sheer number of merchants that accept their cards. Their valuations may seem a bit pricey, but I think they’re justified given slowing earnings growth in many parts of the market. I also expect both companies to benefit as more people worldwide shift from cash and checks to plastic and other forms of electronic payment.
|Q:||If the U.S. economy moves toward the later stage of the business cycle, how might you reposition the portfolio?|
Lee: My big push is to upgrade quality, especially when market volatility gives me the opportunity to buy better-quality names at discounted valuations. To evaluate quality, I examine a number of measures, including quantitative data such as return on equity—an indicator of profitability—and qualitative assessments such as the strength of the franchise.
In addition to upgrading quality, I’ve added to some more defensive segments that I think are more likely to do well in the late stages of the recovery, including property and casualty insurers and certain types of REITs. I’m also interested in individual stocks that seem really cheap relative to their long-term intrinsic value. They can be defensive plays if the valuations get low enough. At this point in time, generally speaking, I think it’s critical to stay focused on both valuation and credit risk.
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