The financial sector was, up until the end of October, one of the last great remaining value trades of the financial crisis. However, since Donald Trump’s election as president of the U.S., financial stocks have been on a tear as the market bets on higher interest rates and inflation following a Trump-induced fiscal spending splurge.
Where can investors find value?
Since the beginning of November, the SPDRÂ Select Sector Fund (ARCA:XLF, Financial) is up 21% outpacing the Standard & Poor's 500 by 12.6%. The big question is, does the financial sector still offer value or has the recent rally corrected the sector’s valuation disconnect with the rest of the market?
Before this financial rally, a large number of banking stocks were trading at a discount to tangible asset value per share. In some cases, this remains the case although, for the most part, the valuation gap has closed.
Take Bank of America (BAC, Financial); at the beginning of November, the shares were trading at a price-book (P/B) ratio of around 0.75. After rallying by around 20% the shares are trading at a P/B ratio of 0.95 and price-tangible book ratio of 1.4. Citigroup (C, Financial), meanwhile, has seen its P/B ratio increased from 0.64 to 0.8, and the bank’s price-tangible book ratio is now 0.93.
Similar valuation increases have occurred across the banking sector. The big issue value investors face is that there is a certain amount of expectation baked into banking stocks. Whereas before investors were undervaluing the sector as they believed interest rates would never head higher and the sector’s profitability would always be terminally impaired, there now seems to be a belief that bank profitability will significantly increase.
This change in sentiment has erased the margin of safety that existed before. The problem is that if the Trump bump that is now expected does not emerge, investors will be left holding the bag as there is almost certain to be a rerating of bank stocks lower.
Uncertain outlook
Trying to second-guess the incoming president’s actions does not seem to be a sensible investment strategy. Considering investors have already placed a significant premium on bank stocks thanks to the belief that high levels of inflation will drive interest rates higher in the near term, it might not be sensible to bet on further gains until there is some more clarity on what the future holds for banks.
That being said, there are still some pockets of value to be found in the U.S. financial sector. The rally has not yet spread to small-cap banks, which tend to be illiquid and fly under the radar of institutional investors. Publicly traded banks such as Community Shores Bank (CSHB, Financial), Northwest Bancorporation Inc. and Great American Bancorp Inc. (GTPS, Financial) all trade at price-tangible book ratios of less than 0.7 although their small sizes may put many investors off. Ally Financial Inc.Ă‚ (ALLY, Financial) is one major financial institution that remains attractively priced with a margin of safety as it trades at a price-tangible book ratio of 0.7 and forward P/E of 8.5.
The margin of safety
The margin of safety principle is fundamental to value investing. Prior to November, many financial stocks traded with a margin of safety that offered investors potential for upside if fundamentals improved. However, after the sector’s recent rally, the margin of safety for many financial stocks has now evaporated, and increased expectations are already baked into stock prices. Only time will tell if the market got ahead of itself, but without the margin of safety, many large-cap financials now appear to be unappealing for value investors. Still, pockets of value remain in the small cap, but these institutions are often penny stocks that are unsuitable for a large number of investors.
Disclosure: The author does not own shares in any company mentioned.
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