A Tough Five Years
Redwood increased its portfolio weighting in financial stocks during the third quarter of 2012. This marks a significant change because beginning in the second quarter of 2007 Redwood strategically reduced its exposure to financial stocks, particularly banks. At that time, multiple risks including deteriorating credit quality, net interest margin pressure and a decline in the important housing market damaged the investment case for financial stocks. The group started underperforming in the summer of 2007, more than a year before the collapse of Lehman brothers, TARP and the start of the Great Recession. For the next five years ending June 30, 2012, financials stocks have been the worst performing US equity sector by a wide margin (see following table). The challenges of the past five years, while well documented and still not completely alleviated, have diminished enough to create a more favorable environment for financial stocks.
What Has Changed
Financial stocks appear more attractive today than at any time since 2007. Stocks are benefiting from improving fundamentals including credit quality, loan volumes, a nascent housing recovery, and consumer deleveraging. Improvement in these trends is causing upward estimate revisions by Wall St. analysts, while valuations remain relatively cheap. The federal government has largely liquidated its holdings of large financial institutions, making the industry more attractive for private capital, and a resumption of dividend payments from many banks. The bull case for financials hinges on the following fundamental drivers:
Credit Quality Improvement. During recessions, bank loan credit quality deteriorates, as non-performing loans and charge-offs spike as business slows. The Great Recession was no different. However, over the past two years, non-performing loans and charge-offs have declined precipitously as the economy recovered. Further, there appears to be more opportunity for improvement in non-performing loans as current levels are still above the long term average. Since the banks built significant reserves in 2008 and 2009, and non-performing loans should decline further, lower charge-offs combined with additional reserve releases could translate into upside for bank earnings.
Corporate Loan Growth Acceleration. In order for banks to exhibit sustainable earnings growth, they must show loan growth. Corporations spent the past five years paying down debt and hoarding cash. Companies have dramatically improved their balance sheets and regained their financial flexibility. As a result, in Q2 12 capital spending reached its highest level since 2008. To finance this growth, corporations have returned to the banks. Consumer and Industrial loans grew in excess of 10% in 2012 after contracting during 2008, 2009 and 2010. A continuation of positive loan growth should support consistent bank revenue and earnings growth.
Housing Recovery. Housing is another critical driver of financial company results because mortgages and home equity loans represent approximately one-third of industry loan volumes. The housing market is demonstrating multiple signs of recovery and reversing the negative trends that began in 2007. Among the signals that the housing industry is starting to recover are:
Existing Home Sales. Excluding the month when the US government first time buyer tax credit expired, the level of monthly existing home sales continue to hit new post-Lehman records.
New Home Construction. In the third quarter, housing starts reached their highest level since the Lehman bankruptcy. While the pace of new construction remains far below the previous peak, the trend is showing consistent improvement.
Higher Home Pricing. The S&P/Case-Shiller Home Price Index saw another monthly increase in its last reported data. Through July 2012, the average price increased 1.6% for the 20-City Composite. Moreover, all 20 cities recorded positively monthly changes for the third consecutive month.
Lower Inventory. Existing US home inventory declined in August 2012 to its lowest level since April 2006. After peaking at more than 12 months of supply, the latest reading implies only 6 months of inventory according to the National Association of Realtors.
Mortgage Growth. Mortgage loan growth has resumed in 2012 after shrinking during the past four years. With rising home values, tight lending standards, and higher required down payment levels, the mortgage business should generate improving profitability for lenders.
Consumer Deleveraging. The consumer spent the past five years retrenching by saving more and paying down debt. In addition, the significant decline in interest rates helped lower interest expenses on variable rate debt and allowed for record levels of mortgage refinancing. The debt service burden on the US consumer is now at its lowest level since the early 1990s (see following graph) and personal interest payments (excluding mortgages) have declined to a 50+ year low. As a result, the consumer has changed from being a risk to becoming an opportunity for financial services providers.
Stocks Attractive. Financial stocks, particularly banks, appear to be more attractive today than at any time in the past five years because of strong fundamentals combined with reasonable valuations. Financial stocks are starting to generate positive earnings surprises and experiencing positive earnings estimate revisions as Wall Street analysts underestimate the recovery factors. The stocks are trading at low absolute valuations and levels below historical averages. In addition, the dividend yield on many of the financial stocks (2.3% - 2.6%) is above the yield for the average S&P 500 stock (2.0%). However, many financials, banks in particular, were forced to cut or eliminate the dividend during the recession. The improvement in credit quality of their portfolios has enabled many banks to reinstate their dividends. Those that have reinstated the dividend have payout ratios in the 10% - 25% range compared to the historical average of 35% - 50%, which suggests that future material dividend increases are possible. Equally important, investor sentiment towards financials remains negative, creating an opportunity for capital inflows as fundamentals continue to improve.
Still Being Selective
While the key underlying trends for the financial companies have definitely improved, all is not perfect. The record low interest rates are pressuring the profit margin for banks. Those companies with European exposure, mostly the money center banks, remain vulnerable to the political, financial and currency situation in Europe. In the US, the impact from Dodd-Frank and other regulations is still not completely clear. Even the areas demonstrating improvement have challenges as the absolute level of charge-offs and underperforming loans remains above historical averages, the housing recovery remains nascent and fragile and the consumer remains anxious. This bottoming process, however, creates opportunities for select areas such as regional banks, credit card companies, mortgage servicers, transaction processors and insurers. Companies in these areas are benefiting from the recovery and demonstrating positive earnings surprises and revisions and are the financial areas the Redwood team find most attractive.