Rising interest rates may have created a drag on U.S. banks' mortgage and refinancing business, but they have also served to boost their net interest income, a key profit metric. With further support from healthy consumer spending, major U.S. banks have posted strong second-quarter earnings.
Strong earnings results have created a tailwind for the stocks of lenders, particularly those that reported higher net interest income. For the quarter to date, the S&P Banks Select Industry Index is up nearly 7, handily topping 5.6% gains for the S&P 500 index, for the same period, as of July 22.
Yet, some U.S. bank stocks are trading at a substantial discount to their intrinsic value, indicating attractive entry points for long-term investors looking to add exposure to the financials sector. These well-capitalized financial institutions are well positioned to weather economic and systemic disruptions caused by major global economic setbacks.
Charles Schwab (SCHW) is a brokerage, banking, and asset-management firm. The company is among the largest firms in the investment business, with over US$8 trillion of client assets at the end of 2021. Nearly all of its revenue is from the U.S.
“Our top picks for a rising interest-rate environment,” says a Morningstar equity report, adding “Charles Schwab will have material near-term and long-term growth in earnings from rising interest rates.”
The largest driver of the company's earnings is interest rate-related revenue, currently accounting for over 50% of net revenue. Given the U.S. Federal Reserve is expected to fairly aggressively increase interest rates to rein in inflation, “higher interest rates applied to Schwab’s banking business that has over US$400 billion of deposits will lead to significant earnings growth,” says Morningstar sector director, Michael Wong, who puts the stock’s fair value at US$84.
He forecasts a 9% compound annual growth rate for net revenue, much of which “is attributable to higher interest rates.”
After the merger with TD Ameritrade, trading revenue has become more material and is about 20% of net revenue. “A combined Charles Schwab-TD Ameritrade is a financial sector powerhouse that will be able to compete in an environment where traditional industry lines have increasingly blurred,” says Wong.
Client asset growth is another key driver of revenue. “Approximately 30% of the company's net revenue is directly from asset management and administration fees,” adds Wong.
Charles Schwab’s wide economic moat, or sustainable competitive advantage, flows from its massive scale and industry-leading cost efficiency.
Independent broker/dealer LPL Financial Holdings (LPLA) provides a platform of proprietary technology, brokerage, and investment advisory services to financial advisors and institutions. The company had nearly 20,000 advisors on its platform managing over US$1 trillion of client assets, at the end of 2021.
Apart from independent advisors, LPL provides services to more than 2,500 advisors at banks and credit unions and more than 3,500 advisors licensed with insurance companies.
LPL’s fortunes are closely tied to interest rates. “Being a wealth management firm, LPL has earnings that are highly exposed to changes in the stock market and interest rates,” says a Morningstar equity report, which forecasts “over the next three years, we wouldn't be surprised if higher interest rates increase gross profits by over 35%.”
The stock remains one of Morningstar’s top picks for a rising interest-rate environment. “LPL Financial should have significant operating margin expansion from a rise in short-term interest rates,” says Wong, who recently lowered the stock’s fair value to US$221 from US$232, prompted by decreasing client assets due to the recent decline in the stock market.
Annualized production retention, a measure of recurring advisor revenue, has averaged over 95% over the past 10 quarters, with retention ranging from 93% to 98%.
Wong forecasts a 10-year compound annual growth rate of around 9% for revenue, and operating margin expansion in mid- to upper teens “as the company benefits from rising interest rates over the next several years.”
A diversified bank, Capital One (COF) is primarily involved in credit card lending, auto loans, and commercial lending. The lender specializes in credit cards, a segment that accounts for more than 40% of its total loans and provides roughly 66% of net revenue. The bank’s remaining business mostly consists of commercial loans and auto loans through its consumer banking segment.
Capital One boasts over US$250 billion in assets and has a smaller branch network than its traditional banking peers, using its online and mobile channels to acquire customers and service its accounts. “The focus on online bank accounts has allowed the company to establish a national presence broader than what its narrow branch network would traditionally allow,” says a Morningstar equity report.
The bank reported mixed second-quarter results with strong loan growth being offset by heavy spending and a continued normalization of credit losses and provisioning. Net revenue grew 12% year over year to US$8.2 billion, with net interest income being the primary driver of growth.
Capital One's future value is sensitive to expectations for net interest margins, the speed of recovery of credit card receivables and how well the company manages its non-interest expenses.
“On a more positive note, we anticipate Capital One to be a beneficiary of rising interest rates and we expect its net interest margins to expand to 7.1%, as we calculate it, by 2023,” says Morningstar equity analyst, Michael Miller, who pegs the stock’s fair value at US$155.
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