As with the Great Depression, we believe the lessons learned from the financial crisis of 2008 dramatically reduced the banking sector's risk and improved its safety and soundness. Our largest U.S. banks today hold 96% more capital relative to their risk-weighted assets than before the crisis. In addition to more capital, banks have also reduced risk through tighter underwriting standards and a greater focus on compliance. Their underwriting was put to the test in 2020 and passed with flying colors.
Rather than being part of the problem, our nation’s banks were part of the solution as we dealt with the pandemic, extending credit, deferring collections and helping administer government programs. More importantly, even after significantly increasing reserves last year in anticipation of loan defaults that thus far have not materialized in a significant way, every one of our major bank holdings remained profitable and built capital through the worst economic downturn since the 1930s.
For Banks, More Capital = Less Risk1
Percent Increase of Tangible Common Equity/Risk-Weighted Asset Percent
|Bank of NY||7.6%||13.1%||+73%|
|Bank of America||4.7%||12.0%||+155%|
An often overlooked characteristic of the financial services sector is its long-term growth. In fact, over the last 30 years, the earnings of the S&P financial sector have grown at more than 6% per year, twice the rate of GDP even after paying above-average dividends along the way. Beyond this sector growth, well-managed financial companies can take market share from sleepier competitors, allowing them to post truly impressive growth rates for decades. We refer to such companies as growth stocks in disguise, as investors often fail to appreciate that robust long-term growth can be found in this relatively mature industry.
Steady Compounding Machines2
S&P Financial Index 5-Year Cumulative EPS Growth
Wide Dispersion Between Price and Value In Financials3
For more than a decade, the earnings of the financial sector have risen as a percentage of the S&P 500 Index's overall earnings (illustrated by the green area in the chart above), while their relative valuation has fallen. This combination of rising earnings and falling valuation presents investors with a wonderful opportunity to buy financials at bargain prices.
The magnitude of this discount is reflected in the fact that financial stocks are now the cheapest group in the S&P 500 Index and trade at their lowest relative valuation in decades as seen in the chart below.
Financials Are Attractively Priced4
Relative P/E for S&P 500 Sectors
Interest Rate Sensitivity
As investors fret about the possibility of higher interest rates, many financial companies stand to benefit, as higher interest rates increase earnings. For insurance companies, higher interest rates benefit investment income, as float is invested in higher yielding bonds. For banks, higher rates increase the spread between deposits and loans. For example, based on the regulatory disclosure of our top bank holdings, a relatively modest increase of 50–100 basis points in interest rates would drive a 24% earnings increase in the first year alone.
Normalizing Interest Rates Would Increase Earnings5
Earning Sensitivity to Higher Interest Rates
|Bank of America|
|Bank of New York|
Because many banks now hold levels of capital far in excess of historical rates, they have the ability to drive significant shareholder value in the form of dividends and share repurchases—even in the unlikely event that net income does not grow.
To understand how a company that doesn’t grow can still generate good returns for shareholders, imagine a hypothetical bank with a market cap of $12 billion and net income of $1 billion per year. As shown in the example below, if the company allocates 35% of net income to dividends and 65% to share repurchase, the gradual reduction in shares outstanding drives a steady increase in earnings per share, dividends per share and stock price, even without any change in net income or the price-earnings ratio. Compounded out over five years, the powerful alchemy of share repurchase and dividends turns no net income growth into an 8.6% compound annual return for shareholders. What’s more, this return could easily be enhanced by any growth in net income and any expansion in the price-earnings multiple from today’s depressed levels which we believe is likely.
The Importance of Capital Allocation:
How No Growth in Net Income Becomes an 8.6% Total Shareholder Return6
Example assumes net income allocated 35% to dividends, 65% to share repurchase
|Hypothetical Davis Financial Holding||Today||Next Year||Year Five|
|Earnings (no growth)||$1.0B||$1.0B||$1.0B|
|Dividends Per Share||$0.35||$0.37||$0.46|
|P/E (stays constant at 12x)||12x||12x||12x|
To be successful, long-term investors in financials must always consider risk. For reasons discussed above, we believe many of the traditional risks of the financial sector—including capital, liquidity, credit and interest rates—are low. Furthermore, while regulatory risk always bears mention, the substantial reregulation of the industry following the financial crisis seems to have largely put this risk behind us for another generation.
Today, the risk most on investors’ minds comes from Silicon Valley in the form of innovation, disruption and so called fintech. However, the challenges and opportunities of innovation are nothing new to the financial sector. Over the last 50 years, for example, banking has faced disruption from the invention of the money market fund, the mortgage-backed security, junk bonds, interest rate swaps, non-bank financials, the ATM, branchless credit card issuers and the internet banks, to name just a few.
Yet throughout this period, banks have proven masterful at incorporating innovation into their core business models, often with the help of regulators who understandably grow nervous when unregulated institutions make too many inroads into the economically critical financial sector. While we carefully study today’s innovators, the long history of financials incorporating innovation into existing business models is reassuring.
One current example that bears this out is peer-to-peer payments, an idea popularized by a Silicon Valley startup called Venmo. In response to this innovative new model, the banks created a similar platform called Zelle, which now processes nearly twice as much volume as Venmo. While we are always on the lookout for disruptive change, history teaches that financial companies are more likely to incorporate innovation than to be dislodged by it.
In the decade following the financial crisis, financial companies demonstrated a powerful combination of resiliency, profitability and growth while their share prices languished. This disconnect reached a stunning crescendo during the COVID crisis when panicked sellers raced for the exits, making the financial sector one of the worst performing groups of that period. The sharp recovery from this overreaction is just the beginning of what we expect to be a decade of revaluations as investors come to appreciate the durability, steady growth and low valuations of a carefully selected portfolio of financial leaders. These attributes, combined with a sensitivity to higher interest rates, shareholder-friendly capital allocation and a demonstrated ability to incorporate innovation, make financials the most attractive blend of risk and reward in today’s market.