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All Contents © 2019The Kiplinger Washington Editors
By James Brumley, Contributing Writer
| May 7, 2018
Prospective borrowers might not be thrilled about it, but the ongoing rise in interest rates is proving a boon for one group of people: investors in financial stocks. The higher interest rates go, the more money there is to be made on loans and clients’ cash balances, which provides a significant boost to bank stocks and shares of other financial institutions.
Banks and brokers already have benefited from the four quarter-point hikes we’ve seen imposed since the beginning of 2017. Bank of America (BAC) reported a 9% year-over-year improvement in revenue from its consumer banking during the first quarter, mostly attributable to deposits and loan growth. Brokerage firm Charles Schwab (SCHW) grew net interest revenue 26% last quarter, to $1.3 billion. Indeed, nearly three-fourths of the market’s financial stocks have posted Q1 results, and 78% of those companies have managed to top expectations.
More of the same kind of growth could be in the cards for the foreseeable future; too. Economists anticipate at least two and maybe even three more rate hikes before 2018’s end.
These are the best financial stocks to buy right now, not just because of the broader trend backing the sector, but also thanks to bargains borne of recent market weakness. Here are 10 of the top prospects in the financial sector.
Data is as of May 4, 2018. Dividend yields are calculated by annualizing the most recent quarterly payout and dividing by the share price. Click on ticker-symbol links in each slide for current share prices and more.
Market value: $299.8 billion
Dividend yield: 1.5%
If you’re looking for financial stocks that not only benefit from sheer size but also are highly diversified, Bank of America (BAC, $29.30) is a one-stop solution. Checking, loans, savings, brokerage, underwriting, wealth management and more – BofA does it all, and does it all over the world.
There’s a downside to size, of course. That is, it can be tough to muster meaningful year-over-year growth. As Wells Fargo analyst Mike Mayo asked of last quarter’s lackluster earnings improvement, “Should we expect more of a benefit from that (tax cuts and higher interest rates) in the future? And if not, why, or how long does it take?”
The grilling, however, seemed to look past the fact that Bank of America did muster relatively meaningful growth last quarter ... for a bank of its size and complexity. Business loans grew 5%, while consumer banking revenue grew 13%. Per-share profits of 63 cents rolled in better than the 59 cents analysts were anticipating.
For an organization of its size, with all of its moving parts and as far removed from the front lines that its top management is, Bank of America’s first-quarter numbers were actually quite robust. In the meantime, with more rate hikes in the queue while CEO Brian Moynihan continues to cull costs.
Market value: $7.0 billion
Dividend yield: 9.3%
Do you like dividends? Take a look at Ares Capital (ARCC, $16.31), a business development company (BDC) that is paying out dividends worth more than 9% of its value on an annualized basis now, and that has consistently dished out that payment since 2012.
A business development company is, as the name implies, a fund established with the intent of getting young businesses off the ground. Funding is usually offered via a loan, though sometimes convertible loans and even outright equity are used. Whatever the case, BDCs are a way of investing in a basket of small-business loans that wouldn’t otherwise be available to investors, and Ares Capital is a particularly well-managed BDC.
There’s a bonus in owning a business development company right now, however.
In March, Congress passed a spending bill that included the Small Business Credit Availability Act. In short, the new law allows BDCs to double the amount of debt-based leverage they’re currently allowed to use. The result will be business development companies that make more money for each dollar’s worth of capital they tie up.
Ares shareholders haven’t approved the use of the new rules yet, but the company’s management is moving forward as if they will.
Courtesy Mike Mozart via Flickr
Market value: $76.7 billion
Dividend yield: 0.6%
We just noted how well brokerage outfit Charles Schwab (SCHW, $56.09) did last quarter as a result of rising interest rates, but it also performed admirably on other fronts. Asset management fees were up a bit, while trading revenues grew just a little less than 5% year-over-year. That’s a solid comparison against the first quarter of 2017 – the first full quarter following President Donald Trump’s surprising election success that sent plenty of investors into a frenzy.
Perhaps the most compelling detail of Schwab’s first quarter, however, was the 39% year-over-year improvement in net income. Just a little extra top line “oomph” translated into a great deal of bottom-line growth.
The underpinnings of that profit breakthrough are still in place, too.
But arguably the best reason to choose an investment of Schwab over any of the other online/discount brokers isn’t even tangible. That’s CEO Walter Bettinger, who may be as in touch with what’s going on in the marketplace as any CEO could be. He has the guts one needs to be a pace-setter instead of a follower, recently saying, “If you have the courage to disrupt yourself, you actually are in the strongest position as an entrenched company.”
Market value: $82.5 billion
Dividend yield: 2.3%
In terms of size, US Bancorp (USB, $50.34) isn’t quite up there with bank stocks such as Citigroup (C) and Bank of America. Its market cap of $82.5 billion, in fact, is only a fraction of the 12-digit capitalizations its bigger brothers sport.
Don’t let the smaller size fool you. US Bancorp is run as well as, if not better than, the banking industry’s “big boys,” and could be a nice way to diversify away from the downside of being big. That is, the most prolific targets can turn into proverbial punching bags when the trading crowd turns into a mean mob. Last quarter’s 4% improvement in revenue and 14% profit expansion verifies that USB is enjoying the benefits of increasing demand for increasingly profitable loans.
And the best may be yet to come.
The Federal Reserve has been kicking around the idea of lowering the capital-retention requirements all banks must meet to pass the so-called “stress tests” the Fed imposes on a regular basis to make sure the nation’s banks wouldn’t be crushed should we suffer a repeat of 2008’s subprime loan meltdown. Although such a measure would prove helpful for banks of all sizes, some think the positive impact would be particularly helpful for smaller, regional banks.
It’s only a possibility at this point, but it would further improve the risk-reward profile of USB shares.
Market value: $7.3 billion
Dividend yield: 6.6%
The Carlyle Group LP (CG, $21.45) is in the same vein as Ares Capital, though it’s technically not a business development company. Rather, it’s a private-equity firm, meaning it owns stakes (usually controlling ones) in companies that aren’t publicly traded. Getty Images, Wesco Aircraft and ice sculpture outfit Arctic Glacier are just some of dozens of companies in The Carlyle Group’s portfolio.
The formula works more fluidly than a conventional mutual fund because not only do mutual fund managers have to pick stocks, but their funds’ values also are impacted by market volatility. For private-equity firms, a holding’s value is primarily determined by its capacity to produce cash; there is no “net asset value” to speak of. On that note, the trailing price-to-earnings ratio of 9.2 and forward-looking P/E of 7.7 makes Carlyle an especially attractive prospect. So does the 6%-plus dividend yield.
Private equity also supplies built-in diversity that the stock of any single company could never offer investors by itself.
By the way, The Carlyle Group’s first-quarter bottom line of 47 cents per share handily topped analyst expectations of only 31 cents per share, underscoring the notion that the market is underestimating this firm.
Market value: $2.5 billion
Dividend yield: N/A
The “BofI” in BofI Holding (BOFI, $40.68) stands for “Bank of Internet.” As the name implies, the bank operates entirely online, yet still provides all the same services you’d expect from any conventional bank branch.
It’s a cost-effective structure; the bank’s non-interest expenses are nearly half those of a typical branch-based bank. Its return on equity is better than 90% of its industry peers. That greater efficiency and lower overhead translates into savings being passed along to its customers.
But it’s not just lower prices that are driving double-digit asset and deposit growth. Emmet Savage, CEO of investment app company Rubicoin, said of the company: “I currently own Bank of Internet in my portfolio. At the time of buying, I believed that BoI differentiated itself through technology. Their personal banking and mortgage products are appealing to a new generation of consumers who are rapidly turning away from outdated banking processes and systems.”
Despite gaining 65% during the past 12 months, the stock still trades at a palatable 12.7 times 2019’s projected earnings.
Market value: $54.4 billion
Dividend yield: 1.7%
CME Group (CME, $159.16) isn’t a bank or an insurer. It’s also not a business development company or a private-equity firm. But this financial stock still is well-positioned to benefit from the higher interest rates that the Fed is using to combat rising inflation. It also stands to gain from the ongoing growth of the broad economy.
CME Group is a futures and options exchange that handles much of the country’s trading activity in oil, corn, Treasury bonds and other assets. All these things are seeing more trading activity as the economy heats up and traders become more likely to act.
During the first quarter of the year, clearing and transaction fees (the exchange’s biggest source of revenue) collected by CME Group grew by 23%. The frenzy has persisted in the meantime. In April, the average number of contracts traded per day was up 4% year-over-year – and again, that’s being compared to when the post-Trump-election frenzy still was in full swing. That’s impressive.
A bonus: CME Group makes money whether commodity and stock prices are rising or falling. Those trades drive transaction fees regardless of the direction of the underlying trend.
Market value: $371.8 billion
Dividend yield: 2.0%
JPMorgan Chase (JPM, $108.43) certainly has plenty of similarities to Bank of America. Both offer retail and institutional services, both handle investments, and both stand to benefit from the ongoing rise in interest rates that’s moving hand in hand with economic growth.
BofA and JPMorgan are just different enough, however, that each has earned its own look from investors.
One of those stark differences is JPMorgan’s growth plans that include a whole lot of “thinking local.” Every major national banking chain operates – at least to some degree – under regional umbrellas. But JPMorgan’s regionalization strategy seems to be exceedingly more deliberate and calculated than similar expansion plans from rivals. In the Minneapolis/St. Paul area, private banking services for high-net-worth families appears to be the priority. In Washington, D.C., JPMorgan is trying to develop a 70-branch network for retail consumers. In Philadelphia, the company is expected to mirror its plans for D.C.
We will see if more regionally minded decisions will benefit the bottom line. But observers expect big things. Chris Connell, a banking attorney with Philadelphia-based law firm Stradley Ronon, says, “This has the potential to be pretty disruptive. If they open 50 or so branches, you know they are going to be spending a lot on marketing and outreach to ensure those branches are a success. So it will have a big impact on the competition. It’s pretty rare that a bank enters a market with a splash on a de novo basis.”
Market value: $24.7 billion
Dividend yield: 1.8%
Never heard of Synchrony Financial (SYF, $32.63)? Actually, you may be familiar with this company, even without realizing it.
Synchrony Financial is the finance arm that General Electric (GE) spun out in 2015. You may be a user of Synchrony’s services and not even realize it. If you have a credit card issued by Lowe’s (LOW, Walmart (WMT), PayPal (PYPL), Gap (GPS), Amazon (AMZN) or several dozen other businesses, Synchrony is taking care of a big chunk of the stuff you never see being done.
Intuitively, the business is a double-edged sword. On the one hand, a strong economy spurs more spending, and Synchrony pockets a small cut of larger and more numerous credit-card purchases. On the other hand, with interest rates edging higher and the economy still being cyclical, investors may rationally fear that there’s not an overly compelling future here.
But those doubts may be overblown. The provider of private-label credit cards has strong relationships with the retailers it serves, and it enjoys abnormally high interest rates that it charges those stores’ customers. It could weather most plausible economic storms – and one isn’t necessarily guaranteed to pop up.
Until then, U.S. consumers are still willing to spend, spend, spend. Credit card debt for American consumers hit another record, surpassing $1 trillion last year.
Market value: $20.9 billion
Put KeyCorp (KEY, $19.70) on your list of financial stocks that could outperform their peers for the foreseeable future.
Like US Bancorp, KeyCorp is classified as a regional bank. But that’s where most of the similarities end. KeyCorp is roughly one-fourth the size of USB by market value and operates less than half the number of branches that US Bancorp does. That difference alters how KeyCorp conducts business and grows.
But it’s not necessarily a liability. Indeed, a smaller size in some regards makes KeyCorp nimbler and faster. That smaller size, for instance, may allow its recently unveiled cost-cutting plans to take shape quickly, and with minimal impact.
Where Key’s smaller size can really be felt, though, is with its fast-growing dividend. Despite last quarter’s uncomfortable increase in spending – which is being addressed – investment publication Barron’s recently opined that it expected KeyCorp’s dividend to be 86% higher than where it is now by 2020.
That’s a big jump, even in an environment where higher interest rates will make all banks more profitable. But KeyCorp still is sorting out its 2016 acquisition of First Niagara Group, which not only is an opportunity for further growth, but to cut more costs that could ultimately provide room for a bigger dividend.