Fresh off a year where major equity indices are up 25-30%+, many would suspect it might be difficult to have strong bullish conviction on equity names in 2014 but I couldn’t’ disagree more. To be clear, I don’t have a strong opinion on equity markets as a whole, but secular trends are setting up to provide fantastic opportunities for significant capital appreciation over the next few years in certain sectors.
There’s a number of things that I won’t be banking on for these particular plays. First, these plays are not dependent upon certain factors staying in place which have led to elevated corporate profit margins, namely weak wage growth. It’s very likely the coming years will see wage pressures rising which will undoubtedly place margin pressure on a variety of companies which have reaped the benefit of sluggish wage growth caused by extreme slack in the labor markets. Second, these plays are largely not dependent upon valuation multiples staying or going above historical averages. All things equal, the segments I want to be most exposed to are ones tied to a pickup in consumer lending and a renewal of the securitization markets.
- Bank Disintermediation Creates Opportunity in Non-Prime Lending: In early November I did a deep dive into Springleaf Holdings (LEAF) which is a non-prime consumer lender. All the ingredients are there for Springleaf Holdings Inc (NYSE:LEAF) to continue to excel. Upside exists in their legacy real estate segment for incremental losses to be lower as home prices recover and employment picks up. Competition from large TBTF like financial institutions has all but evaporated as regulators force the banks to stick to their core businesses. Regulatory risk does exist in the form of potential CFPB rulings, but Springleaf appears far more friendly than so called “payday lenders”. Despite the recent run-up in Springleaf’s stock price, I believe the company can earn $2.00 per share in the not too distant future pushing the stock up to roughly $30. Aside from Springleaf, one of my favorite plays now is JGWPT Holdings Inc (NYSE:JGW) which is the brand name in the structured settlements industry. After a busted IPO a few months ago, the company is primed to earn $2.25-$2.50 per share all the while only trading at ~$17. I think the stock can trade to $22-$25 as the story become more well known.
- Bet on a phasing out of the GSE’s and a return of non-agency MBS securitization: Pressure continues to mount for the government to become a smaller part of the mortgage market. The equity plays that will do best in a scenario where reliance upon the GSE’s is reduced are interestingly priced very attractively. A company such as Redwood Trust, Inc. (NYSE:RWT) will benefit greatly from a surge in non-agency securitization issuance as their Sequoia securitization shelf would be front and center. The stock took a hit this summer as the bond selloff created an air pocket in securitization. Longer term there’s catalysts for a return of issuance including a reduction of the conforming loan limit from $417k, higher G-Fees, and increased loan level pricing adjustments. All of these things are very positive at the margin. Private mortgage insurance is another segment that might still have legs heading into 2014. Currently the FHA/VA share of mortgage insurance is at 64% versus 20% in 2007. The FHFA has no desire to remain such a large percentage of this market. Instead of more popular plays like RDN or MTG, I am bullish and long Essent Group Ltd (NYSE:ESNT) which a new fast growing private mortgage insurer with no legacy issues. Other names in this space that I like for next year include PennyMac Financial Services Inc (NYSE:PFSI) where the GP aspect is being far undervalued, and Stonegate Mortgage Corp (NYSE:SGM) which is on track to build up a large MSR book while trading at only 5x EPS in the meantime.
- Small Banks: The best optionality out of all of these picks may indeed be in small banks. Banks have struggled with loan growth as they’ve made a “student body left” from real estate loans to C&I loans. If there’s any froth in lending I believe it’s occurring on the C&I side and not the Real Estate lending side, thus all else equal I’d prefer a larger exposure to real estate. That being said, there are a number of very attractive risk reward opportunities available in sub $1bil banks which are trading at or near 1x tangible book. Many regional banks are trading close to 1.9x TBV but if you’re willing to do the work you can find plays such as First Citizens BancShares Inc. (NASDAQ:FCNCA) trading just above 1x TBV but with credit quality metrics (0.83% NPAs/Assets) and profitability (4.30% LTM net interest margin) metrics in excess of larger peers. The positive optionality for banks comes in the form of interest rates as most banks are asset sensitive. For many banks as short term interest rates rise, the yields on their assets will rise quicker than the costs of their liabilities (deposits). As this happens net interest margins will expand and costs will be spread over a much larger revenue base. There’s nothing wrong with owning a bank at a reasonable multiple with a ROE of 8-10% in this rate environment, but the real upside comes if rates rise and book multiples expand as profitability takes off.
The financial services industry is very different than pre credit crisis but I believe very good opportunities exist in the above companies headed forward due to a number of secular themes. The phasing out of the GSE’s, return of securitization, and return of consumers taking on debt should all be powerful drivers of these companies. Arguably the best part is that these plays aren’t priced for these things to happen, so you’re buying in at arguably very cheap valuations. It’s daunting to make stock picks after a year such as 2013, but great potential exists here, and it’ll be fun to watch.
At this year's annual Robin Hood conference, which was held virtually, the founder of the world's largest hedge fund, Ray Dalio, talked about asset bubbles and how investors could detect as well as deal with bubbles in the marketplace. Q1 2021 hedge fund letters, conferences and more Dalio believes that by studying past market cycles Read More
***The views expressed here are mine alone and do not reflect the views of my employer***