While Investors Sort Out the Fed’s Next Moves, Focus on Banks with the Wind Already in Their Sails

The Federal Reserve just made its third interest rate hike this year, and the fifth since our long, slow recovery began back in 2009 (Seems like yesterday, but that was eight years ago!)

More hikes are likely coming, including at least three in 2018 and two in 2019. It’s the typical Fed “stair step” routine meant to give business plenty of clarity on the pace of rate increases. But some on Wall Street would have you worry about it.

Don’t! Goodness knows the economy has functioned very well at double the current cost of money — and more. It’s the basement-level interest rates we’ve been living with for too long that are neither normal nor healthy.

What’s more, rising rates are long overdue good news for the banking industry. See, banks make money on the difference between what they pay for money (from depositors, other banks and lenders, and the Fed) and what they can charge borrowers on loans.

A rising benchmark rate just means banks can and should begin to charge more for loans, since the economy itself is creating demand for capital — rather than simply surviving on a steady stream of artificial demand from cheap Fed money.

At the same time, it isn’t all wine and roses for banks right now. That’s because of the shape of the “yield curve” – the graphical representation of the yields on various U.S. Treasuries of different maturities.

A “normal” yield curve starts low on the left and increases to the right, because short-term Treasuries yield less than long-term ones. That’s a sign of confidence in the market about future growth. A so-called “steep” curve also fattens bank profits because they can borrow at cheap, short-term rates and lend money out at higher, long-term ones – boosting their profit margins.

An “inverted” curve looks the opposite, and you get one when investors fear the future and worry that the Fed is going to drive us into recession with its rate hikes. That hurts bank margins because banks have to borrow money at high rates and lend it out at low ones.

For the moment, the curve is flattening. That’s an in-between reading that could go either way. If the Fed is right about the economic recovery, we’ll see the curve become more normal (long bond yields will be higher) — and banks will be in high clover as borrowers flock to them for money for all the right reasons.

My advice? It can be tricky to buy bank stocks in a flattening curve environment. The Fed notwithstanding, this could go on for a while. So, the best way to make bank investments right now is to buy high-quality banks with some wind already in their sails.

To find those banks, we turned to the Weiss Ratings screeners, which subscribers to our Platinum service can access (If you’re not a member yet, give it a shot by clicking here.) We ran a screen that looked at two simple measures: Quality and the price-to-earnings growth (PEG) ratio.

Quality is easy to understand. Weiss Ratings gives bank stocks a letter grade based on a conflict-of-interest-free evaluation of their fundamental strength and technical momentum. We believe the better banks can withstand the stresses of a recession, thanks to better lending practices. Plus, if the curve goes wrong, these are safer bets.

As for the PEG ratio, we zeroed in on banks that had a ratio of more than zero but less than 1. A low PEG ratio like that suggests a stock is undervalued to its recent price — because investors are paying less for those earnings than they probably should. Here’s what our Screener results looked like:

Data Date: 12/14/2017

Is there reason to believe that future earnings will be much different from the past? That’s where a deeper dive is warranted once an initial screen is completed. Our PEG ratio, for instance, is based on results over the trailing twelve months (TTM), not future earnings.

Generally, though, solid and stable Weiss Ratings strongly argue that you should expect earnings to be stable as well. That means the combination of a high-quality rating and a low PEG ratio provide a solid indicator of a good potential bank investment.

Take the top stock on our list, Old Second Bancorp, Inc. (OSBC, Rated “A+”). It has very high operating and profit margins over the past two years versus the industry average for each indicator. It also sports a high return on equity and a 12-month total return of 25.2%, well above the 20.4% return of the S&P 500.

OSBC operates 27 branches in seven counties in northern Illinois, and does basic consumer and small business lending.

Malvern Bancorp, Inc. (MLVF, Rated “A”), based in Paoli, Pennsylvania, dates back to 1887. It tends to do family banking and focuses on wealth management and insurance, as well as everyday lending. While only slightly under the A+ banks on our list, Malvern has a sharply higher profit margin vs. Old Second Bancorp (as an example only).

Malvern’s low PEG ratio suggests that investors have undervalued it to the past 12 months of growth. Nevertheless, the Pennsylvania bank has returned 32% to investors over the past year alone.

As time marches on, we’ll eventually return to an interest-rate regime that looks more like the pre-2008 environment. Until then, seek quality first by starting with Weiss Ratings, then asking which banks are better positioned to prosper in the coming years no matter how the curve situation shakes out.

Think Safety,

Gavin Magor