Wednesday, July 17, 2013

Financials Kicking off the Season

With the market hitting new highs, are you one of the many investors looking to reposition your portfolio into the year's end?
As we enter earnings season, the Street has placed the majority of its focus once again on the financial sector. While the financial sector has outperformed the broader markets for much of the last year, it hasn't been exempt from the turbulence we've experienced over the last three weeks.  A slew of our powerhouse institutions, including Wells Fargo (NYSE: WFC) and JPMorgan Chase (NYSE: JPM) have already reported to start off the season. In this article I will review recent reports while offering forward guidance for the remainder of the year.
The mortgage leader
Last Friday Wells Fargo, the mortgage king, reported its second quarter earnings amid high analyst expectations and predictions. Record diluted earnings per share of $0.98 topped analyst estimates of $0.93, and represented 20% growth for the company. If you break down the company's revenues you will find an even 50/50 split between interest generating and non-interest generating revenue streams. While net interest margins slid for yet another quarter, the drop was almost negligible, 2 basis points. The company made up for the decline through strong deposit and lending growth. As a result net interest income moved higher by 2%, reflecting loan growth, securities purchases, lower funding costs, and one more day in the quarter.
The company's earnings report gave us a good look into the real strength of the economy. Credit quality has improved greatly over the last year; in my previous articles I have highlighted the declining delinquency rates within the credit card sector. Wells Fargo benefited, as well: the net charge-off rate declined to 0.58%, or the lowest since second quarter 2006. Going forward, the company should benefit greatly from the continuance of rising interest rates and credit quality. The perfect storm of loan growth and margin expansion will bode well for the company's EPS over the next few years.
Our nation's banker
If you haven't yet watched the History Channel's look at the Men Who Built America , it's a must-watch for anyone interested in history. The series did a great job and service by giving us a clear look at who J.P. Morgan was, and the struggles he overcame to assert his dominance in the financial world. Today, his name still lingers through his company JPMorgan Chase, which reported its second quarter earnings late last week. The company reported yet another strong quarter where earnings per share rose by 32% to $1.60,  significantly higher than analysts' estimates of $1.44.
The quarter was very similar to Wells Fargo in terms of margins and credit quality. Net charge-offs continued to decline to $1.5 billion, down greatly from $2.3 billion just last year. Unfortunately, net interest margins dropped by a whopping 137 basis points, greatly affecting net interest income. Although NII fell by 7%, strength seen out of the mortgage origination business segment (12% growth) hinted at a turnaround in the quarters ahead. Going forward, JPMorgan stands in a strong position to take advantage of higher interest rates and return money to shareholders. As interest rates rise, expect to see the company generate higher NII. Lastly, additional shareholder dividends seem possible with the $3.7 billion increase in Tier 1 capital.
The broad basket
As I've mentioned in articles earlier this year, the Financial Select Sector SPDR ETF (NYSEMKT: XLF) is a good and liquid fund for exposure to the entire financial services industry. Its top three holdings happen to be JPMorgan Chase, Wells Fargo , and Berkshire Hathaway . Exchange traded funds, if you're not familiar, offer the diversification of age-old mutual funds while giving you the ability to transact in them as you would any other stock. The management fee, 0.18%, is well below the industry average, allowing investors to save money over the long term. By avoiding the commissions associated with purchasing the entire sector separately, you will save a great deal of money. As with the two previously mentioned companies, this fund stands to benefit from numerous tailwinds going forward. As credit quality and interest rates rise, everything from credit, to mortgage, to real estate investments trusts will benefit over the long run.
Wrap-Up
While earnings season is just getting started, a number of financial names have reported positive earnings during a difficult environment. I would like you to consider picking up a financial company if you currently don't have exposure to the sector. All three investments vehicles will benefit from two major tailwinds sweeping the sector. As interest rates rise during a period of improving credit quality, the financials will generate higher net interest income.

I originally posted this article on my blog at the Motley Fool!

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