The large cap US financial companies in our basket declined this year, first in February due to investor concerns about falling oil prices and then again in June when the UK voted to leave the EU (Brexit). As is always the case with financials, investors are also concerned about slower than expected GDP growth, interest rates remaining low for longer than expected, credit losses from economically sensitive borrowers, stricter bank regulations, and further fines due to actual or perceived past misconduct. While we share all of these concerns we view them all as transitory in nature.
We have a large investment in financial stocks both in the US and abroad precisely because they are universally hated and cheap. Banking and insurance are critical building blocks of every modern economy and, in our opinion, will continue to generate fair returns for the foreseeable future. Competitive advantages in finance mostly come from size and market share, particularly given ever increasing regulatory costs that drive out smaller players. For these reasons we have mostly chosen to invest in the larger financial companies.
The specific details for each bank and insurance company are different, yet the underlying thesis is mostly the same. The large cap financials in the US were all severely hurt in the financial crisis of 2008. Since then they have been working to repair their businesses, reduce risks, simplify operations, settle regulatory actions, and restructure bad loans.
Moreover, the banks in our basket will benefit greatly when interest rates finally increase since they will be able to earn higher returns on assets with only a minor corresponding increase in the cost of their deposit base. For example, if in a few years interest rates are 2% – 3% higher than today then Bank of America could earn a 12% – 14% ROE which could justify a 1.6 price to tangible book value multiple (currently about 1.0). Combined with 8% annual book value growth over the next 5 years, this scenario could result in bank of America’s stock price more than doubling in the next five years.
The above commentary has been excerpted from a letter to clients of Emerging Value Capital Management.
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