This year’s first quarter was punctuated by some sudden bank failures in March. California’s Silicon Valley Bank and New York’s Signature Bank collapsed after depositors rushed for the exits; the stock price of San Francisco-based First Republic Bank, another large regional bank, has plunged by nearly 90% this year. The stock prices of several other regional financial institutions, such as Comerica and Zions Bancorp, have also taken it on the chin. In the first quarter, the Financial Select Sector SPDR (symbol XLF) fell 5.5%, which was 13 percentage points behind the S&P 500 Index’s 7.5% return from January to March. But stress in the banking system, which grabs headlines, has also created a number of mispriced and attractive financial stocks, particularly in the small- and mid-cap value space.
First let’s unpack XLF’s composition. There are more than a dozen subsectors, including insurance, asset managers, financial exchanges, brokerages and consumer finance businesses, along with banks, which account for less than one-quarter of the sector’s weighting, as measured by market capitalization. In the S&P 500, financials are the third largest sector (approximately 12.8% of index weighting, trailing info tech and health care), whereas they are the single largest sector in the Russell 1000 Value Index, at approximately 20.3%, as of 4/24/23.
Therefore, the first thing to note is that the financial sector is quite diverse and far more than merely banks. But even among banks, there is considerable heterogeneity—for instance, some are really diversified financial institutions with income streams that may include trust and wealth management businesses, asset servicing and custody, or payments processing.
Insurance is Also Diverse
Now let’s examine another financial industry subsector: insurance. As with banks, within insurance there is considerable diversity: life, health, property and casualty insurance, reinsurance, insurance brokers and agents. Some are sensitive to the economic cycle; others, such as health or auto insurance, are less sensitive.
For example, rising interest rates are challenging many industries, but life and property and casualty insurance companies benefit from higher rates because it dramatically increases their investment income generated when they invest the insurance premiums they take in from customers every year. High inflation is eroding the profit margins of many businesses that are unable to pass on all their cost increases to customers. If you own a car or home, you very well may have experienced double-digit price hikes in the past two years when your policies came up for renewal. Property and casualty insurance firms have considerable pricing power and have been able to pass on to policyholders the rising costs of car or house repairs.
In sum, there are abundant investment opportunities in the surprisingly diversified financial sector. There are also some minefields, such as businesses that are overleveraged in a cooling economy or highly exposed to office space in large urban areas, an asset class that is deflating now due to extremely high—and rising—office vacancy rates. The investment rewards in the financial sector will be earned by analysts and investment managers who can dissect balance sheets and cash flow statements and possess the skills and experience to conduct thorough due diligence and research on companies in the financial sector. Having a portfolio manager that has the ability to go long and short -- with such a skill set is in a particularly strong position since, along with investing in the winners, it can also short-sell financial stocks that are vulnerable to current risk factors such as high interest rates and inflation, falling commercial real estate prices and rising nonperforming loans, fickle bank depositors and a slowing economy.