One of the first major industry groups to report earnings every quarter are the banks. Back in March 26 of this year we wrote a Market Commentary suggesting that investors seeking outsized returns would be best served by looking outside of the Financials sector in the future. Our contention was based on several factors. First and always foremost, we believed (and continue to believe) that the fundamental operating environment had not improved enough to justify the massive increase in share prices. We said that “higher capital requirements and increased regulatory scrutiny will suppress returns and profitability (within the Financials sector) compared to historical levels.” Secondly, though, we said that the Financial sector’s weighting within the S&P 500 had returned to its 20-year average (16.5%) following a massive 260% increase in value since the March, 2009 low for the overall S&P 500. We stated that “after all the turmoil in the industry over the past five years, the (Financials) sector still represents the second-largest sector in the economy behind Technology.”
While this analysis was highly rudimentary, simple analyses such as these can sometimes serve to support an underlying investment thesis. Our investment thesis on the Financials this year has been that the stocks, as a group, had perhaps run up too far and too fast relative to the fundamentals. We believe that the banks in particular are finding it very hard to grow their revenue base in the face of weak loan growth, margin compression, lower mortgage origination fees, lower trading-related income, waning improvements in credit costs, and the increased cost of regulatory compliance. In this case, our thesis turned out to be correct. Since our March 26 Market Commentary, the KBW Bank Index (ticker symbol: BKX) has underperformed the overall S&P 500 by 7.1%. The S&P 500 is up 6.2% since March 26 while the BKX is down 0.9% (both excluding dividends). And while the S&P industry weighting analysis was not our primary justification for caution with regard to the banks, it did provide us increased confidence in our investment conclusion.
Where do we stand now on the banks following the underperformance over the past few months? Well, we think it’s going to continue to be a tough slog for bank management teams. The benefits of lower credit costs are dwindling even as the revenue outlook has not improved much. As a result, we think banks will continue to make efforts to grow earnings through cost-cutting. We expect more job cuts, more branch closures, and lower bonuses until either 1) expense bases become more reflective of the weak revenue outlook; or 2) the revenue outlook improves materially. Unfortunately, investors don’t generally assign a high value to earnings growth that results from cost cutting. Only top-line growth is likely to result in multiple expansion for the banks going forward. Oh, and in case you were wondering, the Financials sector as a group remains at over 16% of the total S&P 500 – down 0.4% since March 26 but still just slightly under the 20-year average.
We don’t write these Market Commentaries to toot our own horns. We are simply trying to illustrate that there are many different ways to support an investment thesis, and astute investors should attempt to find several ways to support their opinions. Farr, Miller & Washington practices fundamental, old-school research and employs a clear, well-defined investment discipline. Should individual banks meet our criteria, we will consider investing, but our broad, evidence-based view suggests a difficult operating environment. We could very easily turn out to be wrong if better economic growth leads to higher interest rates (and margin expansion), better loan growth, higher fee income, and incremental improvements in credit. Our crystal ball just isn’t showing that scenario yet, so we are likely to remain underweight banks for a while.
Source: Standard & Poor’s.