With the failures of Silicon Valley Bank and Signature Bank leading to massive deposit transfers from regional banks to mega-cap banks, the banking sector is under duress. Although this trend is now slowing, it has created a challenging dichotomy — big banks have too many deposits and not enough assets to put them into, while smaller banks are stretched for liquidity.
Amid these unique circumstances, the federal government is considering charging the big banks with helping to rescue the regional banks. It remains unclear how the situation will shake out. Right now, the smart play might be to avoid the sector altogether.
Dramatic Change in Banking Sector
For the past 15 years, buying the dip has been perhaps the most rewarding trading strategy to employ. This is because at every hint of trouble, the Federal Reserve has flooded the market with liquidity. But now the Fed is taking liquidity out of the market and might not reverse course until inflation gets much closer to its target rate of 2%.
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While “dip buyers” may think of themselves as savvy investors, they don’t necessarily know how to value a company. The fundamental picture for regional banks has changed dramatically since March 10, when Silicon Valley Bank collapsed. Prior to its failure, there was a widespread belief that heavy investing by banks in long-dated, “risk-free” securities would not cause significant issues.
As long as the banks could hold those funds to the point that the government would pay them back in full, they could then relend that capital to others. But the failures of Silicon Valley Bank and Signature Bank have created great concern — with many people now questioning what will happen if a bank can’t reach that point, which might be three to five years down the road.
In response, the U.S. government has stepped in and stated it will guarantee all deposits at troubled banks beyond the previous $250,000 FDIC limit per depositor. But that doesn’t change the fact that so many banks still have significant exposure to long-dated securities with below-market interest rates due to the Fed’s repeated rate hikes since early last year. So net-interest margins, the primary source of earning for many regional banks, will inevitably be compressed going forward.
The fundamental issue with banks right now is that their businesses have been negatively impacted by the collapses and ensuing developments in the sector. Accordingly, the earning power of banks has changed, and any banking business valuation from before March 10 is basically meaningless now.
More Appealing Options
Amid all these issues, there are several other sectors that my firm finds more appealing. We like companies with exposure to business models that aren’t reliant on economic growth for success, particularly in spaces like healthcare, consumer staples and utilities. Companies within these industries tend to sell products and services that people will buy rain or shine, enabling the growth of free cash flows and earnings even in tough economic environments.
Many of these companies are also resilient dividend payers, with long track records of paying dividends, as well as management teams that are committed to doing so throughout the economic cycle. Dividend-paying stocks tend to hold up well in inflationary environments because many of the companies have pricing power and can thus raise prices to offset any cost increases.
Additionally, we believe it’s pivotal for investors to focus on valuations right now. With interest rates rising from essentially zero to 5%, and the fed funds overnight rate now between 4.75% and 5%, there’s a cost to capital. When a company’s cost of capital goes up, its valuation should theoretically come down. But we haven’t seen that happen in the market as much as expected, mainly because a handful of technology companies continue to get bid up despite reporting layoffs and business slowdowns.
Essentially, we advocate a forward-looking perspective. Backward-looking investors focus on whatever worked last time and think they should rush into that same approach now, while forward-looking investors thoughtfully assess current market circumstances and react accordingly. With interest rates approaching 5%, we believe it’s time for investors to once again care about valuations.
Industry Issues
Back to the banking industry, a couple landmines could be lurking in its fundamentals. First, many banks are still stuck with those under-earning portfolios until their securities mature. Second, there are indications that regulations will be tightened on some regional banks, which would further stifle lending.
The declining performance of banking equities has certainly piqued the interest of investors who focus on dip-buying opportunities. But just because the trend of fleeing deposits has slowed doesn’t mean all is clear. It’s critical to consider the forward-looking fundamentals of these companies.
Too many investors think a stock that’s down 30% automatically represents a great buying opportunity. In reality, that depends on whether the prior price represented fair value for the company, which might not be the case. Even if it did, investors need to recognize that if fundamentals change, so does fair value.
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