Canadian investors largely like banks, because of the stability of business, and the steady dividend income these stocks provide.
However, for investors who would like diversification beyond the big Canadian banking names, the U.S. market could provide a few ideas.
“To start 2018, we were largely bearish on the U.S. banks, as most names were trading at 2 or 3 stars and we felt valuations were too optimistic. That has now switched with many names trading at 4 stars, as prices have become more pessimistic. We continue to think U.S. banks are an interesting place to look given the sentiment currently baked into valuations”, says Morningstar equity analyst Eric Crompton, who points out that now he is more mixed on U.S. bank valuations as the markets have recovered.
“U.S. banks have some advantages over their Canadian peers,” says Robert Wessel, managing partner at Hamilton Capital. Some of these advantages include a larger sector with a wider range, breadth and quality of names to choose from, potential for continued M&A, and a forecast for faster growth – both for the larger U.S. economy as well as U.S bank earnings.
“With over 200 publicly traded mid and large-caps to choose from, investors can build a diversified portfolio across themes, geographies or business emphasis,” Wessel says.
One of the main attractions for domestic investors in Canadian banks is the steady and growing dividend income from these names. How do U.S. banks match up as far as dividends are concerned?
Wessel says that there is no question that U.S. Bank dividend yields are lower than those in Canada, however, he says that investors should focus on total return rather than the composition of return. He points out that banks in higher growth regions often prefer to use their capital to fund loan growth versus dividends. “On a total return basis, banks in higher growth regions can grow their earnings at higher rates which would be reflected in their stock prices. Slower growth banks tend to have higher payout ratios and dividend yields,” he says.
Same risks as their relatives
What about the risks? Wessel believes the risks for U.S. banks are not meaningfully different from Canada, some of which include risk of slower GDP growth.
“However, the biggest risk would be of a policy error by central banks, either in Canada in the U.S. For example, in the correction in late 2018, the market worried that the Federal Reserve’s combination of quantitative tightening and their stated intention to raise rates by a certain amount was not taking into account concerns over slowing GDP growth. Eventually, the Fed communicated they would take these concerns into account and the markets have recovered,” Wessel points out.
He says that the second largest risk is an unforeseen event or a shock to global growth, which cannot be predicted. Some past examples of such a shock are Brexit, or the surprise devaluation of the Yuan in 2015, both of which caused the market to weaken.
Wessel, manager of the Hamilton Capital U.S. Mid-Cap Financials ETF (HFMU.U) believes that the U.S. mid-cap banking space – with a market cap of between US$ 500 million and US$ 20 billion – offers significant advantages over larger cap counterparts.
Here is a list of the top five holdings in the Hamilton Capital U.S. Mid-Cap Financials ETF:
|
Name |
Market Cap |
Weight |
|
SVB Financial |
US$ 12.3bn |
3.1% |
|
Western Alliance Bancorp |
US$ 4.6bn |
3% |
|
Pinnacle Financial Partners |
US$ 4.2bn |
2.6% |
|
Centerstate Bank |
US$ 2.4bn |
2.6% |
|
Iberiabank Corp |
US$ 4.1bn |
2.5% |
Wessel points out that with over US$2 trillion in market cap, US mid cap financial services sector is larger than the Canadian equity market. There are around 180 mid cap banks in the U.S., and merger activity is ramping up in the space.
Mid caps have more to look forward to
“Profitability and growth metrics of large numbers mid cap banks are superior to their large cap peers. The correction in interest rate sensitive sectors last year affected mid cap banks far more than the large caps – as a result, the valuations of these banks are much more attractive now and offer a greater potential for multiple expansion,” Wessel points out.
“We believe bank merger activity will accelerate and expect that mid and small caps will benefit most from the consolidation in US Banks aided by recent changes in bank legislation that favored the mid-caps,” Wessel says.
“Going forward, we see the banks being divided into two groups. The first group will include those that can invest at scale, build their own proprietary technology stacks, and leverage more unique partnerships, while the second group will be populated with firms that have to stand in line and take the products that are offered by the mass-market vendors, which are the same solutions available to any bank (and unlikely to provide any competitive edge),” he notes.
“One of the biggest trends in the U.S. economy is the movement of human and financial capital moving from the Midwest and Mid-Atlantic regions to the Southwest and Southeast, resulting in large disparities within the U.S. in demographics and GDP growth,” he says, adding that this allows active managers to focus their portfolio to higher growth states. Hamilton Capital has a much larger exposure to states in faster growing regions, including Florida, Texas, Arizona, Georgia and parts of California, while avoiding New York, New Jersey and Pennsylvania.
As of the 25th of February, two U.S. regional banks are trading at a discount to our fair value estimates – Ohio-based Fifth Third Bancorp (FITB) and KeyCorp (KEY). Crompton believes that the Fifth Third still has further to run with its expense discipline, and positive operational leverage should be maintained for the foreseeable future, and expects KeyCorp will continue to target middle-market business clients, and believes KeyCorp's improved scale and product capabilities will give the bank a solid competitive position.
