Bank stocks could be the best opportunity for value in 2020
I’ve got two reasons bank stocks are making a comeback in 2020 and I’m not the only one in on the action. Warren Buffett has over $75 billion invested in just five stocks in the financial sector.
In this video, I’ll show you how to invest in bank stocks and reveal Buffett’s five best picks.
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Why Buffett Loves Bank Stocks
OK nation, we’re five videos into our 2020 stock sectors videos and I’m TIRED! Digging through hundreds of financials to analyze two sectors a week is a lot of digging!
So for our look at the financials sector and the best bank stocks to buy now, I got a little help from the biggest bank investor in the world.
Warren Buffett has 44% of his Berkshire Hathaway portfolio in the financials sector, that’s nearly $77 billion invested in bank stocks, payment processors and advisory companies.
And it’s not hard to see why Buffett loves the banks so much. Financials are the cheapest sector in the market right now. This graphic shows the sectors by forward price-to-earnings ratio. The dark blue bar is the current price to earnings analysts expect over the next year while the green bar is the ten-year average PE ratio.
Clear at the end there we see stocks in the financials sector trading for 12.4-times forward earnings which is just about even with the 10-year average at 12.3-times earnings. Not only is that the lowest PE ratio of any sector in the market, 37% cheaper than the nearly 20-times PE multiple on tech stocks, but financials is also one of only three sectors that trade within three percent of that long-term average. All the other sectors are ten- or fifteen-percent more expensive than those long-run averages.
So financial sector stocks speak to the value investor in Buffett but they also come through on another factor very dear to his heart; cold, hard cash flow!
Bank Stocks for Dividend Cash Flow
The financials spin off a dividend yield of 2% with some of Buffett’s picks approaching a 4% dividend. That’s money he can use to reinvest across the portfolio or in other projects.
So I decided to let Warren do a little of the work for this video. I’ll show you how bank stocks have performed over the last five years and share some financial sector funds to give you broad exposure to the theme, but then instead of picking from the 2,400+ stocks in the sector, we’ll look at Buffett’s bank stocks and pick the top five for your 2020 portfolio.
If you’re just joining us, we’re doing 11 videos to reveal the best stocks to buy in each sector of the economy. I’m looking at each sector from tech to energy, consumer goods and utilities to show you how to find the best of breed companies in each and create that diversified portfolio for growth and cash flow.
This is hugely important because even though we’re following the Oracle of Omaha into bank stocks, you have absolutely got to have stocks in those other sectors. It’s going to give you the diversification you need to grow your money while still protecting it from another financial crisis.
What is the Financial Services Sector?
Here’s the 11 sectors of the economy we’re covering and remember, each sector is made up of industries that serve a common need. Here in financials, we’re looking at companies within investment management, insurance, real estate and banks.
The sector has almost identically matched the return on the market over the last year and five-year period.
Of course, the sector was the hardest hit in the financial crisis, losing almost 80% of its value, so even the strong rebound over the last ten years and this is one of the few stock sectors that isn’t terribly expensive right now.
Financial Stocks ETFs to Buy
We’ll get into Buffett’s best bank stocks but first I wanted to show you three financials ETFs you can use to get that broader exposure. These are going to be great if you can’t find an individual stock you like or maybe if you just want an investment into that entire financials theme.
First here is the Financial Select Sector SPDR, ticker XLF, with its 2% dividend yield and exposure to 67 U.S. based companies in the sector.
The fund gives you exposure to the U.S. financial sector by size so we see that banks are a big chunk of that but you’ve also got solid coverage here in capital markets and insurance.
The fund charges a respectably low expense ratio of 0.13% and has produced a 10.6% annual return over the last decade.
The SPDR S&P Regional Banking ETF, ticker KRE, gives you a little more focused investment into U.S. regional banks and a 2.3% dividend yield.
For years analysts have been talking about a wave of consolidation in these smaller regional banks but it’s yet to happen. These are solid banks though with financial flexibility and benefiting from the American consumer. If that wave of consolidation ever comes in, this would be the fund to have.
The ETF holds shares in 122 regional bank stocks with an average market cap of just $10 billion, so we’re not talking about $295 billion Bank of America here. I also like the fact that no single stock is more than 3% of the fund.
For international exposure to the theme, you might try the iShares Global Financials ETF, ticker IXG, and its 2.7% dividend yield.
The fund is still mostly invested in U.S. financials with 49% of assets domestically but you also get some diversified exposure to Canada, the Eurozone and other markets.
A look at the global financials fund against the U.S. financials sector fund, that’s the global fund in green and the U.S. financials in red, one look is enough to make you think twice about this fund. Europe had a much harder time recovering from the financial crisis and the banking sector has been smashed over the last few years on negative interest rates…but there will come a time when it’s just too damn cheap to ignore.
Warren Buffett Bank Stocks
Now let’s look at what Warren has picked out for us in the best bank stocks to buy. I analyzed the financial sector stocks in the Berkshire portfolio to find the best five of the group, the top five to put on your radar.
Buffett actually has 14 financials sector stocks in the Berkshire portfolio so not only does he hold more than 40% of the assets here, this one sector is also nearly a third of the companies he owns.
We’ll look at those top five stocks from smallest to largest investment, counting down to Warren’s biggest bank bets.
The Travelers Companies, ticker TRV, is one of Buffett’s smallest investments with ONLY $794 million in shares giving him control of 2.3% of the company.
Travelers is a property & casual insurance company with 70% of its premium revenue from business customers. Like most P&C insurers, the company has been hit over the past few years by a wave of natural disasters from hurricanes to wildfires but has been able to adjust premiums higher.
This one is a little uncharacteristic for Buffett because most of the insurance business in the Berkshire Hathaway portfolio is owned outright. The industry throws off an amazing amount of stable cash flow that Buffett uses to invest in other projects.
In fact, we’ve seen a lot of talk lately about Buffett’s $128 billion stash of cash and gossip over what he’s going to do with it. Holding that much cash is hitting returns so he’s under pressure to invest it or buy back shares.
I actually think Travelers is one of his most likely acquisition targets. It would fit in with the private portfolio of insurers and is not particularly expensive at this point.
Shares trade for 15.9-times earnings and have come down 13% since July of this year. Earnings are expected to surge 25% over the next year though this is one where the street has been horrible at predicting earnings and management hasn’t given good guidance. I wouldn’t expect earnings to be quite as high as expected but even a decent 15% increase would mean the shares are only about 14-times earnings.
That would be a steal for Buffett in an industry that trades closer to 20-times earnings and I’d expect him to pick up more shares even if he doesn’t make a bid for the company.
Of the nine analysts covering shares of Travelers, the low target is at $126 per share with a high around $162 each or about 21% above the current price.
M&T Bank, ticker MTB, is one of the largest regional banks with $126 billion in assets and branch business across eight states along the east coast.
Buffett and Berkshire holds a relatively small $890 million in shares to own 4% of the bank and have held the position for nearly three decades.
Buffett always looks for good management and you see it here in M&T Bank. The company had the highest net interest margin among 12 competitors in the third quarter and the second lowest percentage of credit loss on loans.
Two-thirds of the bank’s income comes from loans so the low rate environment hasn’t been great for M&T and three rate cuts in the last year haven’t helped. The yield curve has re-adjusted, those long-term rates which are the bank’s income have increased over the past month while shorter-term rates, the bank’s costs, are still fairly low, so that should help drive greater profitability in 2020.
Shares trade for 11.7-times earnings which is about average for the regional banks, maybe a little on the low side. With the bank’s history of good management, I would expect it to trade closer to 13-times earnings. Earnings are expected lower by 3% over the next four quarters, mostly on that rate environment.
Even on a slight earnings decline and a 13-multiple for price-to-earnings ratio, I would expect the shares to be around $175 over the next year. That’s just a little above the average analyst estimate here with a low target of $150 and a high of $200 per share.
American Express, ticker AXP, is where we really get into Buffett’s big investments with $22 million in shares which gives Berkshire an 18% ownership of the company.
So this is a big bet for Buffett, not just on that dollar value. Owning nearly a fifth of the company, Amex is Buffett’s third largest controlling share only behind Kraft Heinz and DaVita.
And to put this in terms of payment processors, Berkshire Hathaway’s $22 billion bet on American Express is almost 8% of the total portfolio. That compares to less than 1% of the portfolio invested in each of the other two big players Mastercard and Visa.
Amex’s advantage has always been in the business traveler and corporate card market. Spending by cardholders in this market is much higher than the consumer side so that’s driven higher rates Amex can charge to process the payments.
Shares trade for 15-times earnings but those earnings are expected 10% higher over the next year which would be very strong growth. One warning though is that while management has done a good job of beating expectations, that fourth quarter, the next one reported is typically the weakest. You can see here they missed expectations in two of the last three Q4 releases.
Analysts see the shares around $122 each on the low end or $149 per share at the high end over the next year. This one doesn’t pay much of a dividend at just 1.4% but the potential for price appreciation is definitely there.
Wells Fargo, ticker WFC, has been one of Buffett’s longest-running bank bets with $22 billion in shares dating back to 1989.
Berkshire Hathaway owns 10% of the bank but it’s been pretty much dead money since 2014. The 3.8% dividend yield is very high but I would expect pressure to be put on management to start moving the stock price.
Shares trade for just under 12-times earnings which is a far cry from the days I remember as an analyst when Wells Fargo used to trade for way higher than all the other bank stocks on a PE basis. Management has not done a good job at guiding expectations and earnings are expected lower by 6% over the next year.
All this has led to the bank’s CEO, Tim Sloan, stepping down in March and replaced last month by Charlie Scharf. That’s usually a good sign but investors might have to wait a couple of quarters to really start seeing improvements from new programs.
Still though, Wells is a good value play in bank stocks and one of the largest in the U.S. It’s much more a consumer bank versus some of the other mega-cap banks like JP Morgan or Goldman Sachs. Analysts have a low target of $46 a share and a high at $60 per share so while the price appreciation might take a year or two to really take off, I think you can be happy collecting that almost 4% dividend yield while you wait.
Bank of America, ticker BAC, is Buffett’s largest bank holding with a $31 billion bet and ownership of 10% in the company.
BofA made some horrible and badly-timed acquisitions right around the financial crisis that have really weighed on the shares. It saved Merrill Lynch from bankruptcy, buying it in 2008 but still paid too much. The acquisition of shady mortgage lender Countrywide Financial haunted it for more than a decade.
The bank has been able to move past these though and shares have taken off since 2016. Shares only pay a 2.2% dividend but have produced a 15% annual return over the last five years.
Shares trade for 12-times earnings which aren’t as expensive as you’d expect given that strong trend in return. Better still is that earnings are expected to climb 9% over the next year and this is one where management has been able to consistently beat those expectations. Analysts have a low target at $28 per share and a high around $45 each over the next year while the average target is right around the current price.
Bank stocks and other financial companies are some of the cheapest stocks on the market right now and could be a great opportunity for long-term investors. Check out the stocks in Warren Buffett's portfolio for the companies with a competitive advantage and a vote of confidence from the Oracle of Omaha.