The clouds over bank stocks aren’t expected to clear anytime soon, fund manager Dave Ellison said, but some names remain attractive based on valuation.

Depending on whether you’re optimistic or unenthusiastic about the sector, the outlook for bank stocks remains mixed.

In a moribund environment for banks with the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank earlier this year, the Financial Select SPDR exchange-traded fund
XLF
is down by 4.9% this year, compared with a 9.6% gain by the S&P 500
SPX.
The SPDR S&P Regional Banking ETF
KRE
has fallen 32.8% in 2023, and the KBW Nasdaq Bank Index
BKX
is down by 26.6%.

“You make money in this space when operating conditions are difficult,” said Ellison, who manages both the Hennessy Large Cap Financial Fund HLFNX and the Hennessy Small Cap Financial Fund HSFNX.

“The bull case is that you’ll make money when things are terrible. The bear case is the business sucks and no one knows how bad it will be,” Ellison said.

“You have to be patient,” he said, because the outlook for banks both large and small remains uncertain for a variety of reasons.

Net interest income has been under pressure due to competition from deposits and narrower profit margins on loans.

Higher-for-longer interest rates are also expected to eat into credit quality for banks.

There are worries over flight of deposits for higher-paying products outside of the banking system, such as brokerage money-market funds.

Jitters around exposure to commercial real estate and unrealized losses in bank asset portfolios persist. The latter dynamic was a contributing factor in the demise of Silicon Valley Bank.

Larger, more diversified banks are performing relatively well in this environment because a larger proportion of their profits comes from noninterest income such as fees on loans, credit-card fees and trading revenue. But the big banks are also facing a dearth of Wall Street deal making such as initial public offerings and mergers.

The Hennessy large-cap fund owns JPMorgan Chase
JPM,
+1.12%
as the most well-diversified bank.

“Everyone loves JPMorgan — they have diversified revenue streams and good control of their deposits, but is the stock going to triple? No. Maybe it’ll double in the next five years,” Ellison said.

The fund also owns Wells Fargo & Co.
WFC,
+2.74%,
which is “looking cheap” on one hand, but on the other hand the stock is trading where it was back in 2013 and has lost ground this year, he said.

The fund also owns Berkshire Hathaway Inc.
BRK.A,
+0.66%
as a “safe place to hide,” as well as a small position in Citigroup Inc.
C,
+3.53%.

Bank of America Corp.’s
BAC,
+2.90%
stock price has come down, but it’s not particularly in favor with bullish stock investors at the moment.

Smaller banks are facing the emergence of a two-tiered financial system, with big, diversified banks taking deposits away from smaller organizations.

Smaller banks are more reliant on their loan books to generate profits, but the cautious environment and increased regulatory costs are causing banks to make less risky loans, which takes money away from their bottom line.

New York Community Bancorp
NYCB,
-0.21%,
which acquired Signature Bank early last year, remains attractive based on its valuation, along with WaFd Inc.
WAFD,
+3.58%
and ConnectOne Bancorp
CNOB,
+5.96%,
he said.

Looking ahead, it’s going to take a few more quarters to see how bank credit quality plays out and when the Fed’s interest-rate hike cycle ends, even as the market expects rates to stay higher for longer.

Ellison said he’ll be focused on nonperforming-loan and early loan-delinquency figures from the banks as credit quality moves to center stage.

The four main pillars of banking — credit quality, interest rates, regulatory adjustments and accounting changes — have all been in play in the past 18 months.

The regulatory regime is getting more challenging, with banks facing higher costs due to loftier capital requirements and compliance with various regulatory initiatives.

These are times when stock-market investors can make profits if they have the courage to wade into a troubled sector, Ellison said.

Ellison’s funds showed strong gains after he boosted investment in the sector in 2020 when the COVID-19 vaccine was announced and the market recovered. Other down periods include 1990, when he bought Fifth Third Bancorp
FITB,
+5.63%
for a dollar a share.

He noted, however, that it’s hard to predict when the current credit cycle will turn in favor of banks.

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