Interest rates are rising, giving lift to virtually every financial stock in 2017. But investors are especially bullish on a few choice stocks, sending shares of Charles Schwab (SCHW -0.06%), SVB Financial (SIVB.Q 42.86%), and Western Alliance Bancorporation (WAL -1.58%) to new all-time highs in 2017.
Here's what investors love about these three companies, and the risks that could spoil their recent rallies.
More bank than brokerage
Most people may think of Charles Schwab as a brokerage firm and asset manager, but banking and bank-like activities generate roughly half of its net revenue. As rates rise, the bank will only become more important to the company's top and bottom line, and bulls have taken notice.
Charles Schwab is emerging as a winner of the ongoing fee war in brokerage and asset management. It hauls in new accounts with low-cost stock trades ($4.95), and some of the lowest fees on its own line of index funds (0.03% per year). It can afford to charge low prices because it monetizes its client accounts in other ways.
One of its impressive tricks is turning a perk for clients -- commission-free trades -- into a steady stream of royalty-like fee income. Schwab puts funds on its commission-free list, and then charges the fund managers a recurring fee based on the amount of assets its clients invest in the funds. Last quarter, Schwab clients had approximately $510 billion invested in other companies' funds and ETFs, netting Schwab a cool $244 million in high-margin fee income.
Even if its clients do nothing with their accounts and simply hold cash, Schwab wins. Its money market funds are a consistent fee generator, though it makes even more when clients sweep their cash into one of its bank account products. Schwab's bank, its prized asset in a rising-rate environment, pays just 0.12% per year on more than $162 billion of client deposits.
When you pay just 0.12% on deposits, you really don't need to swing for the fences with risky loans to generate mind-blowing returns. In truth, Schwab hardly bothers making loans at all. Loans stood at just 10% of deposits last quarter, one of the lowest loan-to-deposit ratios of any major bank. Rather than earn a profit by taking credit risk, Schwab primarily invests its clients' deposits in agency mortgage-backed securities, thus earning a government-guaranteed rate of return.
The investment risk: It's easy to paint a picture where Charles Schwab's profit goes up and to the right at a double-digit clip, fueled by rising stock prices and client bank balances. To be sure, sour loans are unlikely to send its profits off the rails, given the small size of the book and the fact that it primarily originates high-quality residential mortgages. That said, profits would fall off in a stock market downturn, as roughly 40% of its net revenue is generated from variable fees that rise and fall with the ups and downs of the financial markets. Bull markets lead to outsize profit growth, but profits will drop precipitously in a bear market.
SVB Financial has carved out a niche as the bank to fast-growing tech companies and the funds that finance them. Its balance sheet has grown by leaps and bounds, with loans expanding by roughly 17% per year, on average, since the end of 2008.
SVB Financial's deep ties with Silicon Valley give it some advantages in rounding up low-cost deposits. The company ended the last quarter with roughly $47 billion of customer deposits, of which a majority (about 82%) were non-interest-bearing. As interest rates rise, SVB Financial's deposit costs will increase at a much slower rate than the industry average.
On the asset side of the balance sheet, about 43% of SVB Financial's loan book is invested in low-yielding loans to venture capital and private equity funds. These loans generate steady income and tend to pay floating rates of interest, giving it more interest-rate sensitivity. But the real perk of lending to investment funds is that this business line has experienced very few losses over the company's history. The last time SVB Financial charged-off a VC or private equity fund loan was in 2009, and even then, losses were trivial as a percentage of the loan portfolio.
A base of low-risk loans to VC and private equity funds enable SVB Financial to take big risks in its commercial loan portfolio, which includes loans to high-flying venture capital-backed companies. These loans net SVB Financial a mid to high single-digit return from recurring interest income, plus warrants that enable the bank to get equity-like upside if its borrowers go on to become extraordinary successes.
At the end of the last quarter, SVB Financial owned warrants in more than 1,800 companies worth a combined $142 million. Though many of its warrants will expire worthless, a few unicorns here and there can generate massive gains, bolstering earnings in bull markets when venture-backed companies go public at a faster clip.
The investment risk: SVB Financial's commercial loan portfolio is chock-full of speculative credits. While credit quality has been pristine over a multi-decade bull market in venture capital, net charge-offs have historically rocketed in recessions (credit losses jumped to 3.3% of loans in 2000, and 2.6% of loans in 2009). As long as wealth is flowing into Silicon Valley, SVB Financial can look forward to low loan losses and robust balance sheet growth, but it's a very cyclical business, and investors should be cognizant of its outsize exposure to riskier companies with short operating histories.
The "special situations" bank
Western Alliance Bancorporation is an oddball bank-holding company. Its niche lending businesses are its "secret sauce" that make it an outlier among regional bank stocks. The bank deals in unique corners of the financial world, lending to local governments, homeowners' associations, and hotel franchises, just to name a few of its specialty verticals.
A focus on unique business lines gives it a few key advantages. First, Western Alliance faces less competition in hotel franchise loans than it would encounter in plain-vanilla 30-year residential mortgages. That helps it generate loan yields significantly higher than its peers. Its loan portfolio currently yields about 5.7% on average, more than one percentage point higher than loans held by the prototypical regional bank in its peer group.
Second, its focus on special client types helps attract sticky deposits. As an example, its homeowners' association business line had only $157 million of outstanding loans last quarter, but it's responsible for roughly $2.2 billion of low-cost deposits that could be deployed in high-yielding loans elsewhere in the company. (One of the primary functions of an HOA is to build up cash reserves for maintenance and repair costs that may not be incurred for several years, so deposits tend to sit for a very long time.)
Western Alliance's liabilities are a real asset to the company in a rising rate environment. Approximately 45% of its deposits are non-interest-bearing, resulting in rising net interest margin as Western Alliance's asset yields increase at a faster pace than its deposit costs. Thanks to pristine credit quality, high loan yields, and efficient operations, Western Alliance is on pace to generate an 18% return on tangible book value this year, far exceeding the 10% level that most analysts view as the dividing line between "good" and "bad" banks.
The investment risk: Western Alliance lacks the fee-generating capacity of many of the safest bank stocks, thus making it a pure bet on the performance of its loan portfolio. Its high return on equity is fueled by a high-yielding mix of commercial real estate, commercial and industrial, and construction loans, which can turn quickly in recessions. (Note that Western Alliance's net charge-offs rocketed from 0.04% of average loans in 2006 to 2.86% of average loans in 2009.) It's safe to categorize Western Alliance as an interest rate-sensitive bank as rising rates will certainly drive earnings higher, but investors should be mindful that it is very credit sensitive, too.