Interest-Sensitive Financials Poised to Move

 | Mar 19, 2013 | 8:00 AM EDT  | Comments
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One of our highest-conviction recommendations over the past year has been financial stocks. While many of the global and regional banks started their recoveries in the fall of 2011, a number of more interest-sensitive players, particularly the trust banks and brokerage firms, lagged in the first up leg through most of 2012. This group, however has started to lead the financial charge in 2013, and we believe these stocks are still early in this trend.

While we continue to like financials overall, we are particularly upbeat about the heretofore lagging interest-rate-sensitive institutions. Ironically, while macro considerations had kept financials depressed for some time, the macro-reality of inevitable, indeed impending interest rate increases will provide the biggest boon to the trust banks, brokers and select life insurers.

In our view, the higher rates we have seen so far in 2013 are not surprising, and they probably bespeak the beginnings of an upward pattern. This pattern is likely to unfold even without the Federal Reserve unwinding its aggressive quantitative easing program, which is designed to keep interest rates low.

This is not a matter of fighting the Fed. Rather, interest rates should naturally rise, mostly as a reflection of an improving economy, which does not require artificially depressed rates for expansion, investment and renewed hiring.

Moreover, improvements in the global fiscal picture, such as the re-acceleration of growth in China, and especially the reduced fear of an imploding euro zone, also make higher -- really meaning more normalized -- interest rates increasingly appropriate.

One final consideration is a defensive one: Interest rates that are too low for too long run the risk of putting too much cheap money into play and creating more asset bubbles, such as we saw last decade with the housing market.

While there will be negatives associated with a return to rising interest rates, when it comes to financial stocks overall, rising rates will help stimulate earnings. Within the sector, the more interest-rate-centric companies should see the greatest upside leverage to this market change.

Here are three that we think should continue their upward moves.

Charles Schwab (SCHW) will see the greatest and quickest benefits of higher interest rates. Recently, one analyst quantified the benefits by saying that Schwab could earn $2-plus in earnings per share in a normal interest rate environment, compared with the current $0.74 estimated for 2013. The first area to benefit is the net interest margin. The company is currently earning a 1.45% net interest margin but should be able to earn a 3.50% net interest margin, resulting in an incremental $2.6 billion in revenue. The second area is fee waivers on money market funds. The firm is currently forgoing $600 million per year in money market fund fees. These two areas would contribute the lion's share of a significant earnings jump.

State Street (STT) would also see significant and swift benefits from a rising interest rate environment, though not to the degree that Charles Schwab would benefit. State Street should be able to book an incremental $0.50 to $1.00 in earnings above a $4.50 earnings base from a widening net interest income margin and money market fund waivers when interest rates begin to normalize.

The benefits would also come sooner rather than later. State Street is currently experiencing aggressive new account adds, cost savings programs and capital returns that are also boosting returns. Thanks to these trends and actions, many people believe that State Street can reclaim its historical 15-plus price-to-earnings ratio on these higher earnings, compared with its current 13.5 P/E.

MetLife's (MET) earnings and return on assets have been depressed because of negative spread compression and falling investment income levels in a low-interest-rate environment.

Management has done a good job hedging these risks away. So although earnings haven't declined in this environment, they won't rise quickly either when the interest rate environment turns, as the hedges will have to unwind. It could take two or three years before the higher interest rates begin to accrete to earnings by $0.50 or more.

However, the company will benefit much sooner, since lower interest rates significantly depressed MetLife's P/E multiple to a range of 6 to 7 and brought down its price-to-book valuation to 65% of book value. In a higher-interest-rate environment, MetLife shares could trade up to 10x earnings and 1x-plus times book value. Part of these gains will be driven by a recalibration of MetLife's earnings growth rate in a more normal interest rate environment.

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