The financials sector hasn't been a great performer so far in 2018, underperforming the S&P 500 by more than 6%. However, there are some stocks in the sector that have done extraordinarily well. Here's why Morningstar (NASDAQ:MORN), Credit Acceptance Corp. (NASDAQ:CACC), and SVB Financial Group (NASDAQ:SIVB) have all risen by more than 35% so far this year.

A full transcript follows the video.

This video was recorded on Sept. 10, 2018.

Shannon Jones: Welcome to Industry Focus: Financials, the show that dives into a different sector of the stock market every day. It's Monday, September the 10th, and I'm your host, Shannon Jones. On today's Financials show, we'll be diving into the top-performing large-cap financials stocks of 2018 so far. They're probably not the stocks you'd expect. Also, we'll chat about our top financials stock picks, as well. 

I'm joined here by financials guru and all-around great guy, Matt Frankel. I should also add Certified Financial Planner, Matt Frankel. Matt, how are you?

Matt Frankel: Very good! Thanks for that excellent intro!

Jones: [laughs] I'm working on it just for you, Matt! Alright, before we dive into the specific stocks, we should probably start off by talking about the performance of the overall financials sector in 2018 so far. I mean, really, to be honest, it hasn't been that great, particularly when you consider the performance of 2016, 2017, and even things like tax reform and rising interest rates. What gives with the overall sector performance, Matt?

Frankel: Just to run through the numbers really quick, year to date, financials are up less than 2%. The S&P, meanwhile, is up about 8%. But this follows, like you said, a couple of years of really, really strong performance. In 2017, financials barely outperformed the market, but the market was up by 20%, so that's pretty good. Financials were probably the biggest beneficiary of the presidential election in 2016, especially leading up to it. There was a period in early 2016 where the financials sector was looking pretty terrible. It went up from there. As soon as the election hit, financials just went on a tear. 

To put that in perspective, even though they've been a big underperformer this year, and just barely matched the market last year, since the election, financials have outperformed the overall stock market by 7%. That's pretty good. The S&P is up by 35% since the election, financials are up by 42%. That's pretty good performance. 

The catalysts that initially made the financials sector go up were the prospect of lower regulation, as the Republicans took power; tax reform, as Republicans took power, and as it actually happened; and the trend toward rising interest rates, which generally translates to higher profits for banks. As interest rates go up, bank loan rates tend to go up and deposit rates go up at a slower rate. It leads to better profit margins. 

Those three catalysts are what originally pushed the sector up. Now that they've actually happened, we're kind of in a lull right now. Interest rates haven't really done the margin expansion that we've hoped for. If you've applied for a mortgage or a car loan lately, there really hasn't been a meaningful uptick in those loans, especially not comparable to how high the Federal Reserve has raised rates. The interest rate margin expansion has been somewhat disappointing. Tax reform already happened, so that was already priced in. The other one, regulation, we got some bank deregulation, but it didn't help the biggest names in the sector. It was more aimed toward small and medium-sized banks. When you're looking at the financial sector index, it's the big banks that largely drive that higher, and they weren't really a beneficiary of any regulatory reform we've seen so far, anyway.

Between those three things, that explains why, in 2016 to 2017, financials sector was the best performer in the market, and now are in a lull, after all of these things happened.

Jones: Yeah. Definitely, the word lull applies in this case. Let's actually turn the tables a little bit and talk about those stocks that have really been outperformers. I don't know about you, Matt, but when I went and looked at these large-cap stocks that have been outperforming the market, I was a bit surprised at what bubbled up to the top. Let's start with the first one. 

The first one is Morningstar, ticker symbol MORN for our listeners. Many of our listeners and investors will recognize Morningstar as one of the many research firms out there that's dedicated to providing investors, investment banks, asset managers, all the like, with a wide variety of data, research tools, all of that, for stock analysis. Probably most well-known, though, for their five-star mutual fund rating system. That comes to mind most when you think of Morningstar. Matt, were you at all surprised to see that Morningstar was a top performer?

Frankel: Yes and no. Yes, because it's not a company we normally think of when we think of the best bank stocks and what's going to benefit from tax reform, deregulation, what I just mentioned. But, we're becoming much more of a data-driven sector. As in, financial companies are relying on data much more when they can make investment decisions, recommendations, and that sort of thing. From that perspective, it's not that surprising. They're more of a fintech company, than what you would traditionally think of as a financial stock, like a bank. So, I'm not terribly surprised.

Morningstar actually derives their revenue in two key ways. They get licensed-based revenue from pretty much everything that you just mentioned -- their mutual fund rating system, all their research, the data that they produce. They also get assets under management fees for their proprietary investment products. They have their own mutual funds, for example. Morningstar's biggest revenue driver has been the licensed-based portion of their business, meaning that their data-based products and subscription products are selling much better this year than they were a year ago. Their licensed-based revenue is up more than 10% year over year. 

Yes, I was surprised in that the one leading the charge wasn't one of the banks that benefited from deregulation. But when you think of how well fintech as a whole has done over the past couple of years, it's not that surprising.

Jones: Yeah, I have to agree there. I think you hit the nail right on the head when it comes to the data that this company has. Oftentimes Morningstar is the one putting out the analysis and the ratings, and I think sometimes gets lost in terms of an actual good investment. Even if you look over the past 10 years, this stock has actually been up more than 200%, which is pretty incredible, especially for it to be one of those that just floats under the radar.

I will mention, too, what's interesting is, there was a slight blip, in terms of stock performance, that happened in late 2017. It was actually in part due to a Wall Street Journal report that was put out about Morningstar's five-star mutual fund rating system. It basically brought out the point that the ratings weren't as good a predictor of future performance as one might expect. Honestly, not a huge surprise there. Of course, those ratings are looking at past performance. You saw the stock take a slight blip as a result of that. But you actually saw the stock recover quite nicely from that. I think the reason why is because Morningstar really has a tremendous amount of brand power and brand recognition. As you mentioned, the data and the analysis that it provides is the extra icing on the cake for all of those analysts and fund managers that are using it. 

All in all, to see this as a top performer for 2018, surprising, but just like you said, not so surprising when you consider what it is doing.

Frankel: Yeah, and I definitely agree with you, when you're saying their brand power. Morningstar is to mutual fund ratings as your Standard and Poor's is to stock indices. There's no bigger name and in fund ratings out there. And that's only one part of their business. Even so, that's definitely a big driver of their revenue. 

Jones: Absolutely. We've got a well established business, well-known business with Morningstar.

Let's turn our attention to the second stock we've got here, which is Credit Acceptance Corporation, ticker CACC. This company basically functions in the subprime auto lending space. Matt, this is a pretty interesting stock for a number of reasons. One, obviously, the performance. It's a top performer. But I still think there's a lot left to be desired with this stock. What can you tell us about this company?

Frankel: Any kind of subprime lending is a great business, one, in a booming economy like we're in right now; and two, if they get the numbers right. It's really tough to predict how many bad loans are going to pay, how many are going to default. But if you get it right, it can be a very profitable business. 

Subprime auto has really exploded over the past few years. I read a statistic before we recorded that over more than one out of every four car loans right now are considered subprime or deep subprime. There's a big and growing market for this. Not only that people are spending a lot more in their cars these days, the average dollar amount of a Credit Acceptance loan has gone up 34% since 2015, and the average term is longer by seven months, which means more interest income when customers pay on time. It also increases the risk of non-payment, now that you're stretching loans out over a longer period of time, and you're loaning more money. But, so far, the results have been good.

Credit Acceptance publishes the percentage of loans they think they'll be able to collect for each period. So far in 2018, they've exceeded the amount that they thought they would collect, which has been one of the big drivers of their stock performance. Loan volume has gone up tremendously. There's more people buying cars. 20% growth in just the number of loans. 35% growth in the dollar amount of loans just over the past year. These have been big drivers. 

And while the economy's strong, unemployment's low, this could continue. But this is a stock that could get hammered if the economy goes the wrong way.

Jones: Yeah, absolutely. I think with Credit Acceptance Corporation, one of the things to keep in mind is, its business model is so much dependent upon where we're at in a credit cycle. Any time you hear subprime lending in any sense, whether it be automobiles or housing, generally, there's going to be a flag that should come up, as an investor to say, "OK, where are we at, No. 1, in the credit cycle; and No. 2, is this company prepared in the event of a downturn in the credit cycle, as we know will happen at some point?"

Credit Acceptance Corporation does have a pretty unique business model. Basically, it partners with dealers by paying some upfront cash, then splits those future cash flows with the company as the company recovers the advance plus some profit. Obviously, on the consumer side, when you think about consumer subprime lending, as is usually the case, this usually means high financing charges and fees. That, for me, is a flag. 

But also, in looking at the company's overall asset quality -- this is something that I think will be a key area to watch, not just for this company, but really any company that is involved with lending. You've seen the provision for credit losses steadily increase year over year for this particular company. In 2015, it was $41.5 million. Jumped up to $90 million in 2015. Then, in 2017, it was $129 million. This is all stemming from consumer loan performance. Again, this will be a huge area to watch. 

Additionally, you've got collection rates on those loans down. There's even some investigations ongoing with this company. You've got the financial risk that you'll want to pay attention to with this particular stock, but also, too, the regulatory and the legal risk that comes with being a subprime lender.

All in all, kind of surprised to see this as a top performer. But then again, not in terms of where we're at in the credit cycle.

Frankel: This is my cautionary statement: Credit Acceptance kind of feels like one of those mortgage companies before the housing crisis. The market got bigger and bigger and bigger for subprime housing, like it's getting for subprime autos right now. High fees, an uptick in charge-offs. As long as the economy keeps going up and up, and people are spending more and more on cars, then it's looking fine. But as soon as the cycle turns, look out. That's kind of what you're saying there. There are a lot of parallels between the subprime auto market right now and the subprime housing market about 12 years ago. So, buyer beware with this one.

Jones: Exactly, buyer beware. Let's turn our attention to the last of the top three high flyers, and that's SVB Financial, ticker SVB. This is the parent company for Silicon Valley Bank, which specializes in banking services to entrepreneurs and private equity firms. Matt, this company, on the flip side from where we just came from, has really been able to outperform because it's really been firing on all cylinders. What can you tell us about that?

Frankel: Like you mentioned, they focus on private equity and entrepreneurs. Private equity valuations have just been going through the roof over the past couple of years. That has fueled a lot of their gains. They have a lot of venture capital funds. They make a lot of private equity investments. The valuations of those have just been going through the roof and driving their gains. 

They were also a big beneficiary of the deregulation that I mentioned. One of the key provisions of the deregulation that passed is that the threshold for what's considered to be a systematically important financial institution, or SIFI, which is the too big to fail definition, was raised from $50 billion to $250 billion in assets. Well, SVB has $54 billion in assets. Now, it doesn't have to worry about the excessive regulation that comes with being a huge financial institution. That was a big beneficiary there.

Interest rates have also panned out better for SVB than a lot of its peers. The bank has done a great job overall of becoming much more efficient, cutting costs, raising profitability. Just to throw some numbers out there, SVB has a return on assets of 1.75%. 1% is considered good for a bank, and this bank was at 1.04% a year ago. Return on equity, 20.8%. 10% is considered good. They're generating more than twice the return on equity that is expected. It's up almost over 700 basis points from a year ago. The bank is operating right now at a 46% efficiency ratio. Most banks with a brick and mortar presence are happy to be under 60%. 

Not only has private equity been going the right way, regulation has been going the right way for them, interest rates have panned out for them, and they're just on top of that. They're doing a really good job of controlling expenses and becoming a more profitable and efficient institution over the past year or so.

Jones: Absolutely. Really, all in all, this is a really good time to be backing many of the start-ups and funds, investing in the tech space in general. Interestingly, one statistic, two-thirds of VC-backed tech and science companies that debuted in the public space this year were actually SVB clients. A very well-known, very popular backer for many of these start-up companies. You've got that going for the stock. 

Also, just like you mentioned, Matt, this is also a really good bank. They've been capitalizing on all the key catalysts that have been driving the sector forward. And, too, I think there's a lot more room for them to grow in the long-term. You've got a really solid bank, capitalizing on those key sector catalysts, and business is booming. 

I think, in terms of the sector itself, Matt, we've gone through three of the top performers. I'm curious to know, though, from your perspective, what is your top financials sector pick right now? If you had to pick one stock, would it be any of these three? Or would it be one that's maybe not included in this list?

Frankel: Out of the three, I would say SVB. But overall in the financials sector, I really have my eye on Goldman Sachs right now. I love that they're just now starting to get into the consumer space. The Marcus lending platform, a lot of you have probably seen ads for their loans. They're about to get into the credit card business with a partnership with Apple. I don't know of any better way to get into the credit card business than that. 

And they're doing this, which a lot of people aren't getting, without having a legacy branch network like a Bank of America or JPMorgan Chase or any of those do. So, it has an inherent cost advantage, excellent brand power, and tremendous potential to grow their consumer business. They want to do mortgages, life insurance, all kinds of financial products on top of what they're already doing.

I just think that the market's really underestimating the potential of Goldman's consumer banking. It's still trading at one of the cheapest valuations of the big banks. So, that's the one I have my eye on right now.

Jones: That's a good one, Matt, Goldman Sachs. I think for me, I've said it here many times before, I really can't get off of this stock and how well it has done and continues to do -- for me, it comes back to Square (NYSE:SQ), ticker SQ. Many just view Square as a payments company. The thing I love about this company is that it's so much more than that, and really has the potential to become so much more than that. The bank will become a bank at some point. Square Capital right now is a payments company, it's really investing in technology. I think this is where it's really going to pay off for the stock in the long-term and get it beyond just being a payments company. 

It's building a massive ecosystem, not just for consumers, but also for merchants. What you're seeing is, as they are branching out with Square Capital on the lending side for merchants, opens up a huge door on the consumer lending side. I think that'll be a tremendous growth runway for them. Also, too, internationally, the U.S. market is pretty well-saturated with many of these payment tech companies. But internationally, I think, is really where you see the growth potential get enormous. That's why you see competitors like PayPal and Venmo also beginning to dive into that space, as well.

All in all, I feel like Square is a company that is growing and has tremendous growth opportunity on the other side, as well.

Frankel: Yeah, definitely. I will say that, out of the five stocks we talked about on this podcast today, Square's the only one that I own personally. So, I'm definitely with you on that recommendation.

Jones: Well, you heard it here first, listeners: Square, top pick from both of us here today. That's it for this week's Financials show. Just a couple of housekeeping notes. One is, this is actually my last time hosting Industry Focus: Financials. Very bittersweet for me, but awesome, because I'll actually be jumping over to the Wednesday Healthcare Industry Focus show. As a result, this has opened up an awesome opportunity for Industry Focus: Financials, where Jason Moser -- veteran Fool, huge Financials stocks fan -- will be joining everyone here beginning next week. Next Monday, be on the lookout for Jason's first show. Really excited for the ideas and the stocks that he'll be bringing to you. And, of course, I want to say thanks to everyone for tuning in. Matt, thank you for being so awesome, and really, in many respects, expanding my mind in the wide, wide world of financials stocks.

Frankel: It's been a great time! Thank you for having me back so often!

Jones: Any time. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Shannon Jones. Thanks for listening and Fool on!

SVB Financial provides credit and banking services to The Motley Fool. Matthew Frankel, CFP owns shares of Apple, Bank of America, and Square and has the following options: short December 2018 $90 calls on Square. Shannon Jones owns shares of Apple. The Motley Fool owns shares of and recommends Apple, PayPal Holdings, Square, and SVB Financial Group. The Motley Fool has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and short September 2018 $80 calls on Square. The Motley Fool has a disclosure policy.