Financials Are Finding Fans

07/02/2013 7:00 am EST

Focus: ETFs

Samuel Lee

Editor, Morningstar ETFInvestor

More value managers are hitching their stars to the financial sector, says Samuel Lee of Morningstar ETFInvestor.

Warren Buffett is betting big on the financials sector. According to Berkshire Hathaway's (BRK-B) first-quarter 13F filing, the firm's equity portfolio was nearly 40% in financials. It's expected to go even higher on October 1, when Berkshire receives over $2 billion worth of Goldman Sachs (GS) shares.

Other value managers are also betting big on financials. Mutual fund Fairholme (FAIRX) has about 40% of its portfolio in American International Group (AIG), a stake he's maintained for several years.

This, of course, doesn't mean the sector as a whole is still cheap, considering its recent run-up.

Financial firms averaged a price-to-book of 1.3 from 1926 to 2012. Since 1990, it was a bit higher, at 1.6. Prior to the financial crisis, the ratio stood around 2. Now it's around 1.2 to 1.3, which has historically been consistent with a 6% or 7% real return over the subsequent seven years, with wide variation.

At current prices, one can reasonably expect to earn a couple of percentage points more from financial stocks than from the broad market. This isn't terribly exciting, given that financials are more volatile than the market.

What is exciting, however, is the way banks earn money: using low-cost, short-term depositor funding to make long-term, higher-interest loans. If the real yield curve steepens, banks can do relatively well, provided they've hedged their interest-rate risk (as many banks today have done).

This is historically consistent. The financials sector beat the broad market by about 3.7% annualized from the beginning of 1976 to the end of 1985, a period over which interest rates rose.

Banks actually underperformed the market during the early 1970s, because they seem to have been caught off guard by rising interest rates and/or made poor credit decisions. I don't think either is likely today.

The venerable Financial Select Sector SPDR (XLF) is my favorite financials fund. It concentrates its holdings in blue-chip stocks such as Berkshire Hathaway, JPMorgan Chase (JPM), and Wells Fargo (WFC). The top ten holdings make up more than 50% of its assets.

The fund tracks the Financial Select Sector Index, composed of the S&P 500's financial stocks. XLF charges 0.18%.

There is continued pressure on US banks' profitability. Interest-rate spread revenue at most US banks has stayed the same or fallen, and with rates expected to stay low for some time to come, bank margins will remain pressured.

Additionally, increased regulation has blocked banks taking deposits from proprietary trading, debit-card fees have been limited, compliance costs are higher, and unemployment remains high, which generally tends to keep borrowing and repayment rates low.

But US banks have begun cutting staff and branch locations. And stress tests show that US banks generally are better capitalized than in the past, and can withstand serious economic shock.

The mortgage-refinancing boom has resulted in solid fee income, although our analysts are concerned that that has been played out entirely. A stronger housing market also could mean lower default rates and higher valuations of banks' mortgage-backed securities.

For investment banks, low interest rates and better credit spreads led to significant debt underwriting activity in 2012. A stronger economy should help their financial advisory and equity trading businesses.

Persistently low interest rates have hurt life insurers, as economic capital levels fell to new lows. Insurers are looking beyond traditional insurance toward alternative businesses, such as corporate pensions and asset management. They also are likely to boost their allocations to risky assets such as high-yield bonds and illiquid investments, in pursuit of higher returns.

European-domiciled financial firms make up a minuscule 1.4% of the assets of this ETF. However, problems with Europe's banking system could have a contagion effect on large US banks.

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