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Dilantha De Silva
Dilantha De Silva
Articles (152)  | Author's Website |

Gurus Looking Down on the Banking Sector

Bank stocks are cheap for a reason, but contrarian strategists beg to differ

Third-quarter 13-F filings of major investment management companies have been hitting the market over the last couple of weeks.

Investors monitor these regulatory filings not only to find lucrative investment ideas that are loved by gurus but also to gauge a measure of market sectors that are going out of favor among the best brains in the industry.

From my analysis of the recently-submitted documents that I have read, many gurus have divested large portions of their holdings in the financial services sector during the third quarter. The notable guru sells that I want to highlight are listed below:

Buffett added to his stake in Bank of America, but in general, the gurus I follow seem to agree that prospects for the banking sector are not promising.

Value investors have historically preferred investing in this sector because of the stability of returns associated with banks and the attractive dividend yields. Considering the fact that even Buffett is reducing his exposure to the sector, the time may have finally come for value investors to look for other investment opportunities.

Cheap for a reason

In an article published on Nov. 15, I highlighted a couple of adverse developments for banks.

  1. The ultra-low interest rate environment is projected to remain the same through at least the end of 2022.
  2. The surging popularity and cost-effectiveness of borrowing from bond markets instead of seeking funds from banks is siphoning off another traditional banking profit source.

These two points account for just the beginning of troubles for the industry. The second wave of the pandemic is crippling global economic activities once again, which is already proving to be an obstacle for banks - especially since the economy never did truly recover from the first wave.

Heightened health risks will likely prompt monetary policymakers around the world to limit the ability of banks to hike dividends and execute stock buybacks. Such a limitation would trade economic stability and prevent banking collapses, but would not be good for investors in the stocks of said banks. The success of the industry depends on how soon business activities will return to normalcy, but even a return to normal will still see long-term issues for banks due to the continued increase of corporate debt and the long-term decline of interest rates.

Also, the market seems to be pricing in a new fiscal boost of at least $2 trillion in the U.S. Such a boost, if it ever actually happens, would undoubtedly serve the best interests of Americans and the economy. However, what this also means is that businesses might find even less reason to go to banks, especially since the government has already promised to bridge the gap between available funding and their funding requirements.

There is one more negative sign regarding the expected return from bank stocks. According to data compiled by Ned Davis Research, banks tend to underperform the market when commercial traders have a net long position in bond futures. At the end of the third quarter, these "smart money" traders had a record high net long position in bonds, and if history repeats itself, banks might be in for a rough patch in the coming months.

When all these negative developments are factored into an analysis of banks, it's not difficult to understand why the financial services sector is the second cheapest from a Shiller price-earnings perspective.

Source: GuruFocus

There are many reasons to suggest that the sector is cheap for a reason, and investors need to be cautious before investing in bank stocks despite the very attractive earnings multiples at which stocks are trading.

The counter-argument

Even though there are many troubling signs, some analysts believe that things might soon take a U-turn if the global economy begins to expand at a stellar rate. In this case, the cheap valuation levels might soon disappear, leading to handsome returns for investors who were brave enough to bet on this sector amid the turbulent industry conditions. In an interview with CNN Money, CFRA director of equity research Ken Leon said:

"Banks are attractive as value stocks today, and they tend to do well when there is confidence in a cyclical rebound in the U.S. economy. They are undervalued, so for those investors who are looking out 12 months, they could be very interesting investments."

The liquidity positions of the major U.S. banks have not deteriorated considerably despite the challenges faced in the last few months, which is another promising sign. Back in 2008, many banks found it difficult to cope with the global financial crisis because of their weak balance sheets. The unprecedented measures taken by regulators to strengthen the banking system is to praise for the strong position banks are in today. It's reasonable to assume that banks will not collapse this time around even though government institutions had to bail out some companies during the last recession, but the question is whether the sector would be able to report meaningful growth over the next few years.

Takeaway

The macroeconomic outlook for banks is troubling, and many gurus have already decided to reduce their exposure to this business sector that was once a darling of many value investors. This is an ominous sign, as many of these investors who are divesting banks have a reputation for being a step ahead of the general investing public when it comes to identifying operating conditions for certain industries. The high dividend yields associated with banks and the cheap valuation multiples might lure value investors, but to play it safe, I think the best way forward is to allocate only a very small portion of an investment portfolio to this sector to keep concentration risk low.

Disclosure: The author does not own any shares mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I\'m a CFA level 2 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). I am a registered candidate for the Chartered Wealth Manager program as well. During my free time, I enjoy reading.

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