Questions of Value — Interest Rates & Financial Services Stocks
This is the first in a series of memos in which we will address common questions from our clients about the Partners Strategy and Value investing. We welcome your feedback! Please contact us if you have suggestions for future topics. You can also follow us on LinkedIn where we are regularly posting useful content.
Isn’t a large weighting in the Financial Services sector just a macro prediction that interest rates will rise?
This is a question we frequently get from our clients given our portfolios’ approximate 25-30% weighting in the Financial Services sector. To be clear, our large weighting in the sector isn’t driven by an implicit forecast for higher interest rates. Rather, our Financial Services investments reflect a combination of low valuations and business specific self-help opportunities capable of meaningfully improving each company’s earnings power. For instance, the management team for one of our holdings is executing a credible plan to improve their return on tangible equity (ROTE) to 15% from a historical range of 9-12%. Another one of our Financial Services companies is implementing technology and process improvements that should meaningfully improve their efficiency ratio, which is currently 1,000+ bps worse than peers. Neither of these self-help plans are predicated on rising interest rates. Over the next few years, we expect our Financial Services holdings to generate what we view as an attractive fundamental return comprised of high-single digit EPS growth and a 2% dividend yield. In the current market environment, we find this sort of fundamental return profile quite compelling considering it can be purchased at less than 10x forward earnings.
We make our investments for company specific reasons and build our portfolios using a bottoms-up research process. While we don’t profess any great skill when it comes to top-down macro-economic forecasts, it would be naïve not to contemplate macroeconomic factors when evaluating each of our investments’ risk vs. reward profiles. We look for company specific opportunities where macroeconomic variables are asymmetrically skewed in our favor.
We believe an examination of the historical performance of our current Financial Services investments can help address the question of future interest rate risk. We analyzed the performance of our current investments over the last ten years and grouped the results based on whether interest rates were falling, flattish, or rising. We then compared the weighted average performance of these investments to the S&P 500. As you can see in the chart on the following page, history would suggest that if interest rates are flat or rising our Financial Services investments are more likely to be a tailwind rather than a headwind to our relative performance.
We have a diverse set of holdings within the Financial Services sector that spans four insurance companies, two commercial banks, and one auto lender. These companies have already spent years adapting their business models to a low interest rate environment, and we believe they have less interest rate sensitivity than is commonly believed. Our best guess is that interest rates are likely to be flat-to-rising in the coming years, which suggests interest rate trends are unlikely to be a headwind to the relative performance of our current financial holdings. Importantly, if rates don’t rise, we believe our holdings will do just fine.
Admittedly, if interest rates were to consistently decline, then history would suggest our current Financial Services holdings would struggle. A prolonged decline in interest rates in 2022-23 is a risk everyone needs to see clearly when evaluating the prospects of our current investments in the sector. We remain comfortable with this risk relative to the discounted valuations of our holdings at less than 10x forward earnings and the attractive fundamental return profiles for these companies.
In Conclusion, we believe the multi-year risk-adjusted return potential for our Financial Services holdings is compelling so long as interest rates don’t meaningfully decline.
We’d love to continue the conversation. Please contact Patty Shields (firstname.lastname@example.org or 626-304-6045) or your Poplar Forest relationship manager with feedback and suggestions for future Insights. Follow us on LinkedIn where we commonly post useful and informative material.