Many financials have ripped higher in October vs a flat market, off the back of 90% of reporting companies beating estimates; most of them by wide margins. However financials also rallied in June before giving back almost all their gains, and post election waters may be choppy.
Over the coming months, the rally will hold for two reasons – operating leverage and sustainable money flows. In specific, we just saw the beginnings of operating improvements, and can now expect some level of multiple expansion from accompanying money flows.
How rallies hold: We can track how stocks move over time by combining
1) cash flow / earnings growth with
2) multiple expansion / compression on that earnings and finally
3) Share dilution
To use a popular example, below is Apple over the past year. Almost all of the stock’s upside has been from holders willing to accept a lower future return from a higher multiple:
Banks show the opposite story, often generating earnings growth but suffering multiple contraction. Ameris Bancorp (ABCB) is a typical example:
So, where would the cash flow and multiple expansion come from to support recent bank gains?
Part I: The earnings have returned… Most smaller banks are earning what they earned a year ago (below). Some of this is from mortgage, but banks have other levers to pull, including investing current substantial excess cash into mergers, buybacks, and loans to bolster earnings. See arrows below pointing to happier times in 2019, vs recently reported 3Q20 earnings:
…However, the market has given the sector no multiple expansion as yet – most small banks have few estimates, so when using dividends and price / tangible book, the median valuation for small banks remains near March fall-out zone levels, back when we were tracking northern Italy hospitalizations.
Part II: Multiple expansion comes from money flows, which are on deck: Money flows will change in coming months and quarters, for a few reasons:
- Money will flow in from the sector itself This includes buybacks and mergers. 45 banks reinstated share repurchases in the last quarter or so. Another approximately 100 – including the largest banks – should join them in the coming 3 months. On the merger front, industry consensus is the spring is coiled, with reversion to norm dependent on a credit backdrop. Third quarter results, including zero and negative provisions from some lenders, suggest the spring can now release.
2. Money returning from “hideouts”
Between mid March and Third Quarter earnings, no pension fund, endowment or other large allocator lost his or her job by being underweight financials. Those allocators now have a decision to make given recent results. Continue with Nasdaq 100 at 2-3% earnings yield or get 3x that with banks? Own treasuries paying 80bp or get 3% bank dividends on 30% payout?
How much risk is involved? One bank raised defensive common equity between March and today. Only a handful among 800 public banks even cut dividends. This stability has value over time.
You can buy a “cyclical” like Great Southern Bank (GSBC) at 9x rising estimates, 3.3% yield, repurchasing shares, reporting steady results through 2020, or you can buy the market at 21x and half the yield, getting a share of Apple’s 60% multiple expansion off the back of 12% cash flow growth. Further growth is not guaranteed – picking on AAPL, the company accepts ~$10bn a year from Google to protect a search monopoly while charging app store fees that may not hold up well in a blue wave. Can you name a recent Apple product innovation?
The money will flow to where it’s treated best, and banks have a good argument.