Identifying correct investment themes could go a long way in delivering alpha returns to investors. Empirical evidence suggests that investors who are prudent enough to identify macroeconomic developments early, benefit immensely. For example, predicting that large-cap stocks would deliver better returns than their small-cap peers at the beginning of the last decade would have had a tremendous impact on the performance of an equity portfolio.
2020 could be a challenging one for investors, considering the expected slowdown of the American economy. However, there’s every reason to believe the market's performance will be positive this year as well, driven by the success of the phase one trade deal between the U.S. and China. The financial sector will likely be a winner as credit growth will remain robust with expectations for economic growth. While some investors might find picking stocks is the best way to invest in this theme, many others feel comfortable holding a portfolio of multiple banks and financial institutions. This analysis will look at the outlook for this industry in 2020 and will identify a couple of exchange-traded funds that provide meaningful exposure to the sector.
Gurus are bullish on the sector
Evaluating the portfolio weights of renowned investors is a good way to gauge a measure of the sectors and industries they are bullish and bearish on. As evident from the below graph, many legendary investors have allocated a significant portion of their portfolios to the financials sector.
Notably, all these investors have a track record of investing in banks and financials sector companies at the correct time, which indicates it would be a good idea to follow them into this industry.
Banks are brushing off the threat from low rates by improving efficiency
The Federal Open Market Committee decided to cut the headline interest rates three times in 2019, sending a message to investors that net interest margins will likely be lower for financial institutions in the next few years. Fed Chair Jerome Powell confirmed that there will likely be no changes to the policy rates in 2020 as well. Accommodative monetary policy decisions have far outweighed policy tightening since 1995, which has led to an erosion of government bond yields in developed countries over the last 24 years.
Source: Refinitiv.
Low rates, however, have not been able to stop banks from growing their net income. This is because the industry is seeing significant improvements in efficiency. In a review by Community Banking Connections, it was revealed that overhead expenses (noninterest expenses) at many banks across the nation are increasing at a slower rate than total assets, leading to profit growth. This has resulted in an improvement in the return on average assets for most U.S. banks in the last decade.
Source: Federal Reserve of St. Louis
This higher return on assets played a major role in the continued growth of banks’ profitability in this period, which can be expected to continue as rigorous measures are implemented by the management of these institutions to improve the overall efficiency.
The yield curve is steepening; good news for banks
The inversion of the yield curve sent shockwaves through U.S. markets in 2019. The reaction was appropriate as such a phenomenon has preceded the last seven economic recessions in the country. Analysts, economists and investors alike consider this to be a meaningful indication of where the economy is headed. For banks, this is an even more ominous sign as it reflects the inability of financial institutions to charge more from long-term loans than they pay for short-term debt. Theoretically, a wider gap between the two yield curves will lead to an expansion in profit margin for lenders.
Since September, the yield curve has steepened, indicating the economy is on firm footing at the moment and that fears of a recession are overblown. Shweta Singh, an analyst at TS Lombard, shared the reasons behind this steepening in December.
“Coinciding with the growing expectations for a truce in the U.S.-China trade war – confirmed with the interim trade deal announced late last week – and with a bottoming out of world trade, this has pushed long-end yields higher and thus steepened the yield curve.”
A continued widening of these two yield curves would bring good news for financial services companies in 2020, and this expectation for higher profitability will translate into the performance of shares as well.
Big banks could become bigger
Technological advancements are disrupting many industries around the world, and the banking sector is going through rapid changes. Consumers are opting for online service delivery methods and the importance of digitization has never been any higher for this sector. The big banks in the United States have responded by significantly increasing the investments directed toward improving their online presence. Also, these institutions are investing in developing modernized solutions to address the preferences of tech-savvy consumers.
Source: Deloitte.
Cash-rich banks are in a better position to win more customers in the next couple of years, which suggests it would be a good idea to stick with renowned names in the industry. This is because technology-related investments are costing billions of dollars. Early movers to implement robust new features are likely to win, and it’s the big banks that have made the early moves and possess the necessary resources to invest significant amounts.
Valuation multiples are still attractive
The Shiller price-earnings ratio developed by Robert Shiller, a professor at Yale University, is a widely measured tool to gauge the overvalued or undervalued status of the U.S. markets and sectors. The S&P 500 Index is trading at a multiple of 31.8, which is much higher than the pre-financial crisis ratio of around 25. The financials sector is the cheapest behind energy stocks, which confirms that this sector is relatively undervalued compared to the broad market.
Source: GuruFocus.
This is a good reason for investors to focus on bank stocks in 2020 as there is every opportunity for a convergence of earnings multiples with that of the market. However, thorough due diligence should be conducted on each individual security before reaching investment decisions to avoid falling into value traps.
Earnings are expected to grow
The quarterly net income of U.S. banks and savings institutions has grown exponentially since the financial crisis. The stellar economic growth, record-low unemployment levels, disposable income growth and an increased level of supervision and regulation have all contributed to this successful run of the industry.
Source: Federal Deposit Insurance Corporation
According to data from Factset and the Financial Times, the sector will report the second-highest earnings growth in the fourth quarter of 2019 as well (results are currently being released to the public).
Source: Factset/Financial Times.
Even though there could be a decline in growth rates in 2020, many analysts believe banks will continue to grow their earnings this year as well.
RBC analyst Gerard Cassidy wrote:
“Bank stocks need to be owned. The current environment is similar to the monetary policy of 1994-98, when the Federal Reserve tightened and then cut interest rates, and bank stocks outperformed as rates fell.”
The potential for higher net income coupled with cheap valuation multiples present investors with a good opportunity. The best way to play this thesis might be to own a few funds that specialize in financial services companies.
ETFs to consider
When it comes to equity market investments, there’s no guarantee of attractive returns even if the theses prove to be flawless. Such is the risk associated with these types of securities. Arguably, picking stocks is a much more difficult task than identifying the sectors that are expected to grow. Based on the expectations for the financial services sector in 2020 and beyond, the safest way to gain exposure is to invest in exchange-traded funds that provide access to banking stocks.
The Financial Select Sector ETF (XLF, Financial) is one of the well-known funds that invests in this sector. At the end of 2019, the top 10 holdings of the fund included some of the biggest names in the industry, which is a characteristic that investors should appreciate considering the growth expectations for big banks.
Source: ETF.com
The fund, which has a dividend yield of 1.85%, traded at the market price of around $31 on Friday and distributions have grown in each of the last nine years. This is a promising sign for income investors as well.
Vanguard Financials ETF (VFH, Financial) is another fund that provides the same exposure to this sector, but trades at a higher yield of 2.15%.
Conclusion
The financial services sector looks prime to deliver attractive returns to investors in 2020. The biggest banks might stay on top and divert further away from their small peers, which presents an opportunity for investors to exploit. Investing through ETFs is the best way to do this.
Disclosure: I do not own any securities mentioned in this article.
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