The financial sector has had a pretty mediocre year so far, even as the S&P 500 (^GSPC -0.46%) is up 8% and seems to hit a new record high every week. The Financial Select Sector SPDR Fund (XLF -0.58%) ETF is lagging the broad-based index by about a percentage point, and certain big names like Citigroup (C -1.09%) have stalled or even dipped slightly.
However, there are a few reasons to like the banks and other financials over the long run. For starters, these companies are making tons of money, and most of the lingering effects of the financial crisis are finally being resolved. And many are trading for a nice discount to the value of their assets.
Instead of picking individual stocks, perhaps the best way to invest here is to buy an ETF that tracks the sector. And the best financials ETF is the aforementioned Financial Select Sector SPDR Fund, which has the lowest expense ratio (just 0.16%) and the most assets under management among its peers. The fund tracks the Financial Select Sector Index, and its largest holdings are Berkshire Hathaway, Wells Fargo, JPMorgan Chase, Bank of America, and Citigroup.
While history has shown that nothing in the stock market is a sure thing (especially in the financials sector), there are a few catalysts that could push the fund higher in the months and years to come.
Crisis-related litigation may soon end at last
In the five years or so since the financial crisis, companies across the financials sector have become much better capitalized and have done a great job of getting rid of bad or risky assets. In short, the banks are much stronger.
However, one thing that has been ongoing -- and has even accelerated in recent years -- is the litigation expenses stemming from bad behavior leading up to the crisis. Most of this is working its way through the courts, and many banks are happy to pay billions to settle and put the financial crisis firmly in the past.
The largest settlements have come from Bank of America and JPMorgan Chase, which settled lawsuits related to mortgage-backed securities for nearly $17 billion and $13 billion, respectively. And, most recently, Goldman Sachs settled its big lawsuit for $1.2 billion, which means all but three of the FHFA's 18 mortgage-related lawsuits have been settled. There are still pending lawsuits stemming from various financial-crisis issues, but for the most part, the "big ones" are done with.
When there is legal drama surrounding a company, it creates uncertainty that can depress the stock price. This is especially true when you're dealing with lawsuits of this magnitude. After all, when a company might have to pay somewhere between $4 billion and $20 billion to settle a case, the ultimate impact on the company's balance sheet can vary widely based on the outcome of the settlement.
M&A and IPO activity could continue to rise
With the market at or near record levels, there has been a flurry of M&A and IPO activity in recent months.
In fact, the Alibaba group is finally about to complete its long-anticipated IPO, which should be the largest in history. And this is after an already active 2014, in which we've seen large companies like GoPro and El Pollo Loco go public.
So long as the market stays hot, we could see this level of activity continue or even improve as companies see the potential to receive excellent value for their offerings as they go public. During the second quarter, pretty much all banks with investment banking divisions saw equity underwriting revenue pop.
And the combination of a hot market and low interest rates should keep M&A activity high, which is also an excellent driver of advisory revenue for the banks. For example, JPMorgan Chase, the No. 1 investment bank in the U.S. in terms of fee revenue, saw its revenue from advisory fees rise by 31% year over year in the second quarter.
It's not a sure thing, but the upside outweighs the risk
Perhaps the most compelling reason to believe the financial sector could rise is the cheap valuations of the companies that make up the index.
As you can see, the "big four" banks, which combine for about 27% of the fund's holdings, trade very cheaply relative to their book values, both on a historical basis and on an absolute basis. And some banks, such as Citigroup and Bank of America, actually trade for substantially less than their book value.
Basically, this makes me believe there is more upside potential than downside risk here. No matter what the market does, the value of the assets of these companies will serve to buoy the stock price in tough times, and those very assets will make the companies money in good times.
Richard Pzena, founder of Pzena Investment Management, even estimates that bank earnings could even double over the next few years, and in the meantime you can collect a 7%-8% return on assets, which you're already buying at a discount.
So, while there are no guarantees, especially with a correction being called for and a lot of legacy assets still on the banks' balance sheets, there are some compelling reasons to like the financial sector right now.
