Of the 10 broad sectors of the U.S. stock market, the financial sector has benefited the most since the election, advancing 14.3 percent versus 6.7 percent for the Standard & Poor’s 500 index.
This move was based on four key factors: expectations for rising rates to continue; deregulation and eventual easing of capital return restrictions; future economic growth prospects; and the cheapest valuation of any sector in the S&P 500. While banks (retail, wholesale and investment banking) comprise 71 percent of this sector, insurance, brokerage and asset management companies are also included, which stand to benefit for the same reasons.
Up until the middle of 2016, the sector’s largest industry, banks, had been in a secular bear market. This was due to falling returns on equity — a long-term condition that has occurred due to tighter capital standards; higher excess reserves from quantitative easing; central banks’ zero interest rate policy; and, most importantly, declining long-term rates. In the weeks following the U.S. presidential election, the yield on U.S. 10-year Treasurys rose by approximately 50 basis points as investors reassessed their outlook for the country’s economic prospects. The Federal Reserve also raised its target for the Federal funds rate for the second time since the financial crisis (by 25 basis points to 0.50 percent – 0.75 percent) and announced three rate increases for 2017.
[See: The 7 Best Bank Stocks to Buy for 2017.]
While the financial sector has advanced dramatically post-election, the future is still bright. Here are two stocks that may have further room to advance.
Berkshire Hathaway (ticker: BRK.A, BRK.B). Berkshire provides exposure to several different types of businesses, including insurance, industrials and banking firms, which all stand to benefit from rising rates. Because of this diversification, it may be surprising that Berkshire comprises the top weighting within the S&P 500 financial sector (comprising nearly 11 percent). Unlike the rest of the sector, Berkshire typically holds up well during stock market declines, outperforming the market in 18 of 22 corrections of 5 percent or more since the market bottom in 2009.
Berkshire’s insurance division is amongst the largest and most profitable in the world. Annual premiums were $41 billion in 2015, but more importantly, underwriting profit was $1.8 billion and float was $87 billion. Float is effectively borrowed money and the underwriting profit of $1.8 billion implies that Berkshire borrowed money at -2.0 percent in 2015. It would be one thing if this was a fluke year, but Berkshire has demonstrated time and time again that over the long term it can borrow money at extremely low rates. Equally important, it uses this money and the cash flow from its operating business and sizeable investment portfolio to invest in world-class companies, such as Burlington Northern Sante Fe, Precision Castparts Corp. and Kraft Heinz Co. ( KHC), to name a few.
While Warren Buffett and Charlie Munger have clearly built a very impressive company, they have also groomed the next generation of leaders who are proving to be as capable of managing the company. Because of its vast moving parts, Berkshire is best measured on a price-to-book basis, which currently stands at 1.5x and has ranged between 1.2x and 1.6x in the last five years. Book has grown at 6.4 percent per year, but Berkshire has long prepared for a rising interest rate environment and is a potential beneficiary of this trend. Furthermore, an increasing portion of Berkshire’s earnings growth is coming from wholly-owned companies whose true value is probably vastly understated at 1.5x book. Also, many of these businesses, such as the rail business, have accelerated their capital expenditures in recent years, which has potentially suppressed the growth of book value.
[Read: What Happens to Berkshire Hathaway After Warren Buffett?]
The S&P 500 is trading at 3x book, and Berkshire’s operating businesses are as good, if not better, as the typical S&P 500 company. If book value were to grow 7 percent per year for the next three years and the company were to exit 2019 at 1.6x price-to-book, Berkshire has the potential to deliver a 9 percent annual return. The company pays no dividend and only repurchases stock if the price to book is less than 1.2x.
U.S. Bancorp (USB). U.S. Bancorp is the fifth-largest bank in the U.S. with a large presence in the Midwest and Western states. Sixty percent of the bank’s income is generated from its spread business (i.e., core lending and deposit business) and the balance is fee based, such as wealth management and payments.
The key to long-term profitability for any bank is strong expense control and disciplined lending standards. These areas are both core competencies for USB, and they have been able to offer competitive lending options while still delivering among the highest return on equity in the industry. A steeper yield curve (i.e., long-term interest rates rising faster than shorter-term rates) is a very favorable environment for banks and this a likely scenario given rising inflation, low unemployment and strong demand for loans. A 50-basis-point (.50 percent) improvement in lending spreads from 2.8 percent currently would improve profits by 18 percent even if loan growth remains flat. If this margin expansion occurs over three years, the lending business of USB would grow profits by 5.6 percent per year.
In its non-fee business, the company carries strong operating leverage, so 2 percent to 3 percent real GDP growth could drive 5 percent earnings per share growth per year for the next three years. Assuming a combined 6 percent EPS growth per year for the next three years, 2019 earnings could potentially reach $3.95. Assuming a price-earnings multiple of 16 in 2019 would imply a $63 price target, or annual appreciation of 5.8 percent per year. Furthermore, the dividend is yielding 2.08 percent and is projected to grow 10 percent per year. If the economy remains on its current trajectory over the next three years, an annual total return of 8.3 percent per year for USB appears reasonable. However, if loan growth improves by 2 percent per year, it is likely that the annual total return of the stock approaches 10 percent per year.
BRK.B and USB are just two examples of stocks investors should consider when looking to profit from the advances in the financial sector. The post-election action in this sector has been positive, and future growth and investing opportunities are likely.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
Leslie Thompson and clients of Spectrum Management Group own BRK.B and USB.
More from U.S. News
7 Stocks That Could Save Your Portfolio
7 Tips for Finding the Best Target-Date Retirement Funds to Buy
The 10 Best Dividend Stocks of 2016
The Rise of the Financial Sector and Where to Invest After the Election originally appeared on usnews.com
