This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Could the Fed Pull Off a “Soft Landing?
Wall Street breathed a collective sigh of relief last week on better-than-expected inflation figures. The S&P 500 rose 3.1%, breaking its 3-week losing streak.
The Fed, it seems, might be pulling off a “soft landing.”
It’s a possibility, even if it’s a remote one. The Fed raised interest rates by 3% in 1994 without triggering a slowdown. And 6% mortgage rates today have already started cooling the housing market, as my real estate agent kindly reminds me every time we talk.
But 1994 was also an outlier among recessions, much like when I scored 185 in a game of bowling. Nine of the past eleven rate hikes since the 1960s have ended with some economic slowdown, and today’s inflation rate is far higher than the 5% seen in the 1994 cycle.
In other words, we’re not out of the woods just yet.
Some economists are even gloomier. On Sunday, the Bank for International Settlements reported that inflation expectations are reaching a “tipping point” where inflationary psychology could soon become “entrenched.” Split happens, apparently.
So what can investors do if rates keep rising and last week’s rally goes from a good game into a “dead cat bounce” down the gutter?
That’s where an investment in financial firms comes in.
9 Stocks to Survive a “Dead Cat Bounce”
Let’s start with a disclaimer:
Investors tend to hate financial stocks.
Not only are financial firms generally slow-growing. Their high leverage and opaque accounting make them prone to blowing up. Barely a decade goes by without a financial crisis sending some part of the world into a tailspin.
Even Eric Fry of InvestorPlace — an expert in turnarounds and value investing — generally shuns the sector. His current recommendations virtually avoid all mention of the lagging sector.
But financial firms do have their uses.
First, there’s diversification. As a group, financials are 11.2% of the S&P 500, making them the third-largest sector behind tech and health care and over twice as large as the entire energy sector. Buying zero financials leaves a Wells Fargo-sized hole in your nest egg.
Second, financials are the only S&P 500 sector that generally benefits from rising rates. As interest rates increase, banks and insurers can reinvest customer deposits for higher net interest margin (NIM). That makes them natural protection against rate rises. On the other hand, non-financial firms suffer from higher borrowing costs and a rising cost of capital.
Finally, well-run financial firms can earn phenomenal returns. Insurance company RLI Corp (NYSE:RLI) has risen 27,000% since 1982, three times faster than firms like Coca-Cola (NYSE:KO) and five times Merck (NYSE:MRK). And who can forget Warren Buffett’s Berkshire Hathaway (NYSE:BRK-A, NYSE:BRK-B) — a holding company that owes much of its success to early investments in American Express (NYSE:AXP) and Geico.
Finding the Winners
So how can investors pick long-term winners while avoiding the next Bear Stearns?
You’re looking for financial firms with good growth and earnings…
…But not too good.
In banking, the most aggressive firms with the highest growth rate are also those with the greatest risk of blowing up.
It’s like driving a Lamborghini down city streets — you don’t want to hit a pothole in a luxury sportscar when you only have 2 inches of under-body clearance.
Similarly, investors need to approach fast-growing financial firms with the same skepticism I treat in-town Lamborghini drivers. Companies from Lehman Brothers to Robinhood (NASDAQ:HOOD) raced ahead with unsustainable business models, only to eventually implode.
Meanwhile, the financial versions of a 2002 Toyota Tacoma trundle over these potholes without skipping a beat. Steady growers from RLI Corp to First Republic Bank (NYSE:FRC) have managed over two decades without a single year of losses. Their shares have provided stunning 10,000%-plus returns without anyone realizing.
The data backs this up.
For this study, I take all Russell 3000 financial stocks over the past ten-year business cycle and divide them into quintiles of expected revenue growth. REITs, life insurers, exchanges and brokers are excluded for their significantly different business models.
Stocks are then bought and held for one year to measure returns.
When it comes to revenue growth, it turns out that middle-of-the-road companies perform best. An investor buying the third quintile of revenue growth firms would have outperformed those at the extremes by 4% per year.
Earnings growth provides a similar conclusion, though quintiles 1 and 4 do slightly better.
Ordinarily, high-growth companies will do better. But in the case of financial firms, there are two fundamental reasons why middle-of-the-road companies perform better.
First, high-performing financials tend to avoid excessive leverage. Re-running the same data on banks only (since insurance companies have different leverage rules), we’ll find that banks in quintile 4 of debt-to-equity provide the best returns. Firms in the highest bracket do less well.
Secondly, well-run banks focus on profitability rather than unfettered growth. Some of the top financial firms, from Capital One (NYSE:COF) to US Bank (NYSE:USB), are well known for only expanding into markets where they can reach scale.
That prudence translates well into investor returns; the quintile of highest ROE financial firms outperforms the lowest quintile by 2%.
These conservative firms stand in stark contrast to their riskier counterparts. High-flying startups such as LendingClub (NYSE:LC) and Rocket Companies (NYSE:RKT) managed to achieve stunning growth as private firms but have seen prices drop 90% and 70% since their IPOs.
In other words, if you want to profit from banks and insurance companies in the long run, it pays to identify the ones with the best underwriting standards that actively sacrifice short-term business for long-term success.
High-Quality Financial Firm Picks
To identify high-quality firms, the Profit & Protection quantitative model takes these findings and runs them in reverse on Russell 3000 financial stocks:
- Selective Insurance (NASDAQ:SIGI). A+
- W R Berkley (NYSE:WRB). A+
- Everest Re (NYSE:RE). A+
- PNC Financial Services (NYSE:PNC). A+
- Allstate (NYSE:ALL). A
- JPMorgan Chase (NYSE:JPM). A
- Charles Schwab (NYSE:SCHW). A-
- Northern Trust (NASDAQ:NTRS). B+
- US Bancorp. B+
Join me on Thursday this week when I pick out which firm makes it onto the core Profit & Protection “buy” list.
Maybe Let’s Go Golfing…
If it isn’t clear by now, I’m a far better golfer than a bowler. When your only opportunity to go bowling is at your nephew’s birthday party, there’s only so good you can get.
Meanwhile, I’ve been golfing since I turned eight… the age when my parents finally decided they deserved some peace without me in the house. When it comes to accuracy, practice makes perfect.
It’s a lot like investing in financial firms. Experienced analysts develop a sense for when financial statements seem too good to be true. Given the extreme limitations of modern GAAP accounting for financial firms, analysts can often require years of practice to read between the lines.
Regular investors can also do well by following simple rules. Banks and insurance companies that 1) earn consistently high returns and 2) refuse to overexpand are generally superior bets. Though these “gutter guards” might not help you strike every time, they’re surely better than blindly rolling the ball down the lane and hoping for the best.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.