VFH: Banking Is the New Oil (NYSEARCA:VFH) | Techy Kings

[ad_1]

Alex Wong/Getty Images News

The past two weeks have seen bank stocks perform better as a string of better-than-expected earnings releases sparked a significant rally. Both JPMorgan ( JPM ) and Bank of America ( BAC ) beat expectations, and the overall banking sector rose when their release comes out. The highlight of the bank’s third quarter was Bank of America’s net interest income, which rose 24% on a constant basis inverted yield curve observed during that period.

Treasury spread 2/10 years

2/10 year treasury spread (FRED)

Many people were surprised to see banks show relative strength last week. It is well known that an inverted yield curve is bad for banks. They borrow at the short end of the yield curve and lend at the long end, so lower long-term interest rates than short-term rates should squeeze their margins.

One reason why banks beat expectations is because the yield curve has not “inverted” as many believe. The curve now inverted is the 2-year/10-year treasury yield spread, which plots the 10-year yield minus the 2-year yield over time. That has reversed by 28 basis points as of this writing and has been reversed for most of the year. The real yield curve–which has maturity on the X-axis and yield on the Y-axis–still has an upward slope. Short-term bonds have significantly lower yields than long-term bonds; inversion begins at maturity of one year.

Yield curve

Yield curve (US Treasury Yield Curve)

As interest rates are rising and the yield curve is not PARTIALLY inverted, it’s a good environment for lenders. High interest rates in themselves are good for banks, as they allow banks to charge higher interest rates. Only when the yield curve inverted did this cease to be the case, and today’s yield curve is only partially inverted.

What is a good way to play this bullish environment for banks?

You can try to find banks that you think are better ranked than their peers–I happen to like Bank of America and TD Bank (TD) personally. However, you can skip all that and buy the Vanguard Financials ETF (NYSEARCA: VFH), which gives you exposure to all the big banks, credit card companies and Berkshire Hathaway (BRK.B).

I bought VFH this year knowing that I wanted more exposure to US financials. I see that bank stocks are going down while their interest income is going up. Their earnings declined, but that was largely due to higher provisions for credit losses (“PCL”), which were more of a precaution than actual losses. If the current recession risk is excessive, then the bank will be able to lower the PCL later. I happen to believe that is the case. Media scare stories have trained the public to equate “recession” with “catastrophe.” This leads to binary thinking where there is only rampant expansion or an impending apocalypse. In reality, there is such a thing as a “mild contraction,” and we’re in one today: jobs are up, unemployment is low, and retail sales are steady. If we are in fact in a recession, it will be a moderate one, not a 2008-style downturn. For this reason, banks are still well-positioned to outperform relatively low investor expectations. VFH is a great way to gain exposure to this undervalued sector, especially for investors who don’t have the time or risk tolerance to treat individual bank positions.

Why VFH is a Great Alternative to Individual Bank Shares

There are many reasons why one would prefer a sector fund over a collection of individual stocks. Diversity is the main reason, lack of expertise in the sector is another. Any investor can benefit from diversifying their portfolio, most investors will benefit from diversifying the portion of their portfolio invested in financials. The reason is that financial stocks, especially bank stocks, are very different from other stocks, especially in the way they are analyzed. If you don’t have specific expertise in the banking sector, you may want to skip picking individual bank stocks.

First things first, banks are analyzed using various ratios that are not applicable to other types of companies. Capital ratios, for example. For starters, you have the risk-based capital ratio, which is capital over risk-weighted assets. Then you have other ratios that break down capital into different quality levels, such as the CET1 ratio and the Tier 1 ratio. Finally, there are loss absorption targets, stress tests, and various other things related to capital ratios. The rules on bank capital ratios are quite complex, and you need to know them all to understand how risky individual banks are.

Second, banks interact with macro factors in a rather unusual way. Mainly, they react to interest rates differently than other companies. Higher interest rates reduce the present value of growth companies’ future earnings, and increase the expenses of capital-intensive companies such as utilities. Banks are unique in that they have the potential to profit from rising interest rates. Provided that rates rise in parallel across the yield curve, and the yield curve remains upward-sloping, banks typically profit from rising interest rates. However, if the yield curve is inverted, that may not be the case. In the third quarter, US banks’ interest income increased, which is consistent with the theory that banks benefit from high interest rates. However, it is inconsistent with the theory that an inverted yield curve reduces bank profits from high interest rates. Finally, I think that the strong performance of banks in Q3 is explained by the fact that the yield curve has not “really” inverted; 2/10 year spreads are negative, but not shorter maturities’. The bottom line is that in order to pick individual bank stocks, you need to know how different banks react to interest rates, as some are much more sensitive to rates than others.

Between capital adequacy and interest rate sensitivity, banking stocks have many unique factors that can be a real challenge to understand. In this regard, funds like VFH offer a great way to get started with banking and financial stocks that do not require deep expertise in the sector to get started.

First, you get diversified exposure to US banks, including JPMorgan, Bank of America, Citigroup (C) and Wells Fargo (WFC). So, your risk is spread across various banks with varying levels of capital adequacy and interest rate sensitivities, resulting in a portfolio that can perform well in a variety of different economic conditions.

Second, you get significant exposure to non-bank finance. Besides banks, you also get holding companies like Berkshire Hathaway, brokers like Charles Schwab (SCHW) and credit card companies like Visa (V). Some of these companies performed better than your average bank this year. For example, Charles Schwab is down just 7.3% for the year, while Visa is down just 6.6%. This makes sense, as most large banks have high investment banking exposure, and i-banking is suffering from the collapse of the tech IPO underwriting business. Brokers like Schwab instead profit from fluctuations in whether the market is up or down, and earn higher interest income on their lending operations. So, through VFH, you get heavy exposure to non-bank financials, which have outperformed diversified big banks this year.

VFH is quite cheap

Another interesting thing about VFH is that the fund is relatively cheap. VFH is not a broad market index fund: it is a sector fund that tracks the MSCI US Financial Index. However, it has expenses typical of broad market index funds, including:

  • A 0.10 MER.

  • Good tracking (the fund’s NAV trailed the benchmark by just 0.8% cumulatively over 18 years).

  • The bid-ask spread is 0.02%.

These characteristics collectively indicate that VFH is a cheap fund. There is another form of “cheapness” you can mention in regards to VFH: cheapness of holding. Because the financials are not favorable right now, VFH’s underlying portfolio is relatively cheap, with an 11.1 P/E ratio and a 1.4 price/book ratio. This low multiple is currently available despite the fact that VFH has an average return on equity of 12.5% ​​and an earnings growth rate of 17.5%. So, not only are you not paying much for VFH in terms of fees, spreads and tracking errors, you’re also not paying too much for the underlying stock.

VFH portfolio evaluation

VFH portfolio evaluation (Vanguard Group)

Bottom line

The bottom line about VFH is that it is a cheap fund that invests in industries that are currently out of favor for no particular reason. Of course, the bank’s earnings are down this year, but that’s largely due to the PCL build. Many credit card companies and brokers are doing well. With VFH, you not only get banks, which could see their earnings jump as PCLs come down in the coming economic recovery, but also non-bank financials, which in many cases are performing quite well.

To be sure, VFH is susceptible to many risk factors. An inverted yield curve is bad for banks, and recessions tend to increase credit risk. Nevertheless, all signs point to the fact that, if we are in a recession now, it’s a moderate recession, not a 2008-style slump. Taking the pros and cons of finance together, we can make a strong case that finance is likely to pick up in the coming months. next, just like the oil stocks that happened earlier this year. Personally, I am quite content to be an overweight banker, both individually and through my position in VFH.

[ad_2]

Source link