best ideas financials traditional - jonathan casteleyn, analyst
DESCRIPTION
Investment rationale for positioning within the U.S. Financials sectorTRANSCRIPT
LONGS Market Cap ($MM)
Dividend Yield Short Interest (% of Float)
Sell Side Sentiment
Fundamental Factor
Rationale Risk Units
Bank of America (BAC) $168,250 0.25% 1.0% 46% Positive Value Book value of $20 at a 10% normalized ROE is $2 in EPS – Street is at $1.30
3
Goldman Sachs (GS) $78,000 1.3% 1.9% 21% Positive Quality Institutional trading volume to benefit on rising VIX and FICC expectations are low – good pair against short MS
2
Allianz SE (ALV) $67,000 3.6% 0.5% 51% Positive Value PIMCO outflows are waning and performance is improving – great time to own this value insurer with a dividend yield
3
Capital One (COF) $48,200 1.4% 1.3% 72% Positive Value Still cheap at 10x earnings in one of the few growing U.S. loan categories
3
CME Group (CME) $29,000 2.1% 2.1% 31% Positive Quality Prime beneficiary of renewed volatility in the US – good pair against short ICE
3
Invesco (IVZ) $16,697 2.6% 1.6% 53% Positive Quality Improving distribution – UK retail fears well discounted
2
NASDAQ OMX (NDAQ) $6,700 1.5% 5.3% 61% Positive Value 40% of market share trades off exchange which will change
3
eTrade (ETFC) $6,500 0.0% 3.8% 60% Positive Momentum A potential takeout candidate with US retail back – loan book is improving
1
Och Ziff (OZM) $6,300 6.8% 1.6% 66% Positive Yield Alts have a massive tailwind with Pension reallocation – 10% fully loaded dividend yield too
2
Lazard (LAZ) $6,700 2.3% 0.3% 60% Positive Quality M&A segment is the best in capital markets – still cheap relative to group
3
Legg Mason (LM) $6,000 1.2% 7.0% 26% Positive Value Pension reallocation helps them with still high short interest and low sell side sentiment in this stock
3
Zions Bancorp (ZION) $5,537 0.5% 6.4% 24% Positive Value Regional banks can grow their loan segments with the big banks in the penalty box – ZION still under book value
3
Fortess (FIG) $3,200 4.2% 2.3% 70% Positive Value $3 per share in core management fee EPS + $3 in balance sheet assets is cheap for this $7 stock
1
Federated Investors (FII) $3,400 3.0% 9.0% 15% Positive Value My EPS opportunity is 15% above the Street and sentiment is way too low
2
Wisdom Tree (WETF) $2,400 1.7% 7.7% 66% Positive Momentum Strong grower in secular ETF boom – First mover in Fundamental ETFs
1
KB Homes (KBH) $1,400 0.6% 19.7% 25% Positive Value PHS is turning up which should pull housing equities with it. KBH is a value name out of favor
2
Ocwen Financial (OCN) $900 0.0% 9.0% 77% Positive Quality Now trading at tangible book or liquidation value – like it as a pair against Nationstar
1
Beazer Homes (BZH) $500 0.0% 17.6% 30% Positive Value PHS is turning up which should pull housing equities with it.
2
Market Thesis: I am looking for the U.S. market to tread water in 2015 and put in a moderate decline.
Markets can do four things: Go up a lot; Go down a lot; Go up a little; Go down a little. With EVERY
publishing sell-side strategist forecasting that the S&P 500 will have POSITIVE gains in 2015, this outlook
is already well discounted by the market and thus means it is NOT likely to happen. With these targets
mainly in the +2% to +9% range for U.S. stocks, I put that in the “up a little” category which takes it OFF
the table as an outcome. I think “up a lot” is not likely after 6 consecutive years of positive returns in the
S&P 500 (and for the record the S&P 500 in 140 years of data has never risen for 7 consecutive years),
and I think “down a lot” is off the table as corporate balance sheets are still in much better condition
after the Credit Crisis and general corporate risk aversion. Thus I think with corporate earnings growth
slowing into 2015, and a Fed Reserve that generally wants to get off of emergency policy and move
interest rates up slightly, I think the S&P 500 will be “down a little” in the neighborhood of -2% to -9%. I
am focused on Large Cap Value names to match this defensive posture with solid balance sheets for
Long exposure. Pair trades can be effective in this environment and also shorting Small Cap Growth or
speculative names.
All the major Sell Side Strategists are forecasting gains for the S&P 500 in 2015:
With the rate of corporate earnings growth declining into 2015 which will provide consternation to the
market:
And the S&P 500 is now ahead of the trajectory of unemployment claims which are treading water:
Sector Thesis: Both the Buy and Sell side are still off sides with respect to interest rate expectations and
thus the Financials sector should underperform. The investment community still expects rates (10 Year
Treasuries yields) to RISE throughout the year. However empirically rates have FALLEN after both bouts
of quantitative easing (QE1 and QE2) were wound down and the current tapering program is essentially
that phenomenon in slow motion so unexpectedly, U.S. ten year yields will remain stubbornly low. With
many segments of U.S. Financials still dependent on higher U.S. rates with positive correlations to 10
year yields, we broadly recommend an UNDERWEIGHT position in the sector for now. However there
are some pockets of growth in the sector that do allow for LONG exposure including a trending M&A
(merger and acquisitions market), volatility returning to the market which benefits the exchange
companies, and a recent pickup in demand for consumer credit. In addition, one of the biggest themes
we see in the sector is the revamping of the U.S. pension fund system which is re-allocating rapidly OUT
of equities and INTO fixed income and alternatives, with funded status well improved after the 6 year
run in equities and asset allocation now a function of immunization and the pursuit of risk adjusted
returns. In this scenario we like unpopular bond manager Legg Mason and Allianz and leading hedge
fund Och Ziff. In addition, after underperforming for most of 2014 with weather related issues and also
initial tighter credit parameters, the U.S. Housing complex is starting to turn the corner and should
outperform in 2015. As such we like a handful of homebuilders and the mortgage insurers.
RATE TRAJECTORY IS STILL NOT WIDELY UNDERSTOOD:
Rates as defined by the U.S. 10 year yield empirically DECLINE when the Fed removes quantitative
stimulus. This is NOT widely understood as the bulk of the investment community believes that if a big
buyer of securities is REMOVED from the market (i.e. the Fed from the rate curve), that Treasury prices
must FALL and hence the 10 year yield must RISE. However, the OPPOSITE actually happens as growth
expectations for the U.S. economy FALL with the REMOVAL of stimulus and hence 10 year yields
DECLINE. I view the currently tapering program as a slow motion version of the end of QE1 and QE2
where rates FELL 100 bps in each case. Thus U.S. rates should stay stubbornly low which will hurt many
of the long cases for U.S. Financials.
STILL A RATE SENSITIVE SECTOR:
Running the impact of the trajectory of rates against the major constituencies of the sector, displays the
dependency on 10 year yields. For example the average R value of the Banks and Thrifts segment against
10 year yields (we ran the correlation of stock prices to 10 year yields over the past year) is 0.62. So
roughly 1/3 of the price response of the banks (with an R-squared of 0.36) is explained by rates. The
Banks and Thrifts have the most sensitivity to rates with the Brokers and Asset Managers next, followed
by Specialty Finance, Insurance, and the Homebuilders which are negatively correlated to rates.
BOTTOMS UP SECURITY SELECTION: Just a few charts and thoughts that crystallize our views on our
security selection:
Long OCH ZIFF (OZM), Allianz (ALV), and LEGG MASON (LM) on U.S. pension re-allocation
The biggest theme in our view is the rotation in the U.S. Pension fund system AWAY from equities and
INTO alternatives and fixed income. We have done A LOT of survey work on this with expert calls with
Towers Watson (2nd biggest pension fund consultant) and with U.S. pension now closer to “funded
status” (they went from 70% funded status beginning in 2013 to over 90% funded status in 2014), the
$18.8 trillion market is now immunizing with bonds and replacing equity exposure with alternatives.
Alternatives have 20% share currently but should grow to 30% of the U.S. pension system over the next
decade. This 1% market share growth per year IS A MASSIVE OPPORTUNITY at $180 BILLION IN INFLOW
PER YEAR. We like the 20 year track record at OZM to capture this opportunity and the fund has
substantial scale to handle new inflow. 1/3 of OZM’s client base is U.S. pensions so the relationships are
already established:
LEGG MASON (LM) also benefits from pension re-allocation and this leading bond fund manager has
repaired performance to capture pension net inflows. In addition, we think the struggles at leading fixed
income firm PIMCO under German insurer Allianz are well discounted and in repair and thus with a
strong dividend yield and very strong investment performance that ALV shares are a strong long
candidate.
Long CAPITAL ONE FINANCIAL (COF) as credit card loan growth is just picking up, one of the few
categories of domestic loan growth with an improvement in delinquencies. The Fed’s G-19 data has
accelerated sharply as of late with consumer revolving credit averaging 6.0% annualized growth over the
last 3 months (M/M annualized rates), up from 1% Y/Y growth over the past few years. Credit cards are
a FAST asset and are closely correlated to U.S. unemployment claims which continue to DECLINE year-
over-year. Capital One stock is also CHEAP with continued synergies from the cycle’s acquisitions of ING
DIRECT and HSBC portfolios.
LONG the M&A Advisors and the Exchanges. M&A is the only game in town and we like blue chip
advisors LAZARD (LAZ) and the newly public MOELIS (MC). M&A activity is running at the highest level
since 2007 with the new strategy of tax inversions likely leading to a longer cycle. In addition, the return
of volatility to the U.S. markets with the Fed Reserve lessening its activity in the market should keep a
bid under volatility and thus we like CME Group (CME) and NASDAQ (NDAQ) as U.S. proxies.
LONG the HomeBuilders and the Mortgage Insurers. Generally, Pending Home Sales (PHS) leads
Home Price Indices (HPI) by 12 months, and HPI and the XHB homebuilder index are strongly
correlated. After a temporary slide in 2014 due to weather and some new credit restrictions (QM
rulesets), PHS is starting to positively inflect again on a year over year rate of change basis which
will pull HPI and thus housing equities up with it. In addition, the physical housing stock in the U.S.
generally has been underinvested in which should over time move 800,000 in current starts to
closer to 1.15 million on a seasonally adjusted basis which should power the home builders higher.
Both Beazer Homes (BZH) and KB Homes (KBH) are good candidates to invest in this trend with
low expectations. In addition BZH has had some insider buying recently which has historically
signaled a good entry point.