Ask the Rational Investor: Should You Add Banks to Your Portfolio?

One of the hardest-hit areas of the stock market this year has been the Financial sector, of which, banks have declined the most.

With the stock market making new highs, investors are starting to look at companies whose stock prices have lagged the broader market. Many are concentrating on energy companies, such as Exxon Mobil and Conoco Phillips, or airline stocks.

Unlike airlines, hotels, or other higher-risk areas, banks may offer a compelling investment opportunity.

After the 2008 financial crisis, regulation increased dramatically to help prevent another future disaster. Many of the largest banks are deemed systemically important financial institutions (SIFI), which results in balance sheets that are the safest in decades!

Numerous banks are currently paying dividends that seem attractive relative to other options, with the S&P 500 Financial Sector paying a dividend greater than 2.5%. Some individual securities have even greater dividend yields, such as J.P. Morgan yielding 3% and Huntington Bank 4.5%.

In contrast, a 10-year Treasury bill offers a measly 0.92%, while the yield of the S&P 500 is 1.5% and the Dow Jones is 2%. It is clear that banks offer much higher yields compared to almost any other investable asset class.

Positive vaccine news has changed investor expectations of loan losses due to the hopes the economy improves as the vaccine limits the spread of COVID-19. Loans that are currently in forbearance are less likely to default with an economy returning to normal.

Lower loan losses have caused investors to expect higher tangible book values in the future, and stock prices have started to reflect this change. Banks make money on the spread between what rates they can borrow at and what rates they can lend at. By increasing their tangible book value, banks are safely capable of making more loans – which in a low-rate environment, is one of the best ways of generating higher profits and taking market share.

As bank stock prices rally investors will shift their focus to the long-term expectations of interest rates. The Federal Reserve lowered interest rates in the spring and has told investors that they will not increase interest rates until average core inflation is greater than 2%.

This in turn indicates a timeline for when the Federal Funds Rate could be increased, as most economists expect inflation to hit 2% no earlier than 2023, and likely closer to the beginning of 2025.

Low interest rates will cap bank profits, as net interest margins remain low. Lower than average profitability will shift banks' focus on managing expenses through branch closures and mergers in similar geographic footprints 

A return to normalcy will benefit a number of market-lagging companies. Compared to cyclically challenged companies in industries like energy, banks have robust balance sheets and a number of levers to pull to positively impact profits. Given attractive dividend yields and recent stock price underperformance, banks may be an attractive option for your portfolio!

Sources: Company reports and presentations

Beese Fulmer Private Wealth Management was founded in 1980 and is one of Stark County’s oldest and largest investment management firms. The company serves high-net-worth individuals, families, and non-profits, and has been ranked as one of the largest money managers in Northeast Ohio.