Vanguard Financials ETF: financial stocks are not expensive
Vanguard Financials Index Fund ETF (NYSEARCA:VFH) is an exchange-traded fund that seeks to track the performance of its chosen benchmark, the “Spliced US IMI Financials 25/50” according to its fact sheet; it’s a benchmark index constructed by MSCI with a methodology that caps any position that exceeds 25% of the index and caps positions from 5% to a maximum of 50% in total (i.e. 25/50, a popular method for reducing the concentration of l index/portfolio). The expense rate is only 0.10% (Avant-garde funds are generally cheap), and assets under management were $8.9 billion as of July 31, 2022. There were 372 holdings.
VFH does not just own banks; Berkshire Hathaway (BRK.B) was VFH’s largest position as of July 31, 2022, at 8.54% of the portfolio. Berkshire Hathaway is Warren Buffett’s famous business conglomerate. Nevertheless, the bulk of VFH’s portfolio is made up of conventional financial institutions.
About 40% of VFH is concentrated in its top 10 holdings, which isn’t too concentrated compared to other major indices (which tend to overweight technology companies). Currently, based on historical and SEC yields, VFH’s dividend yield is around 2.2%, which is well below the current US rate. 10 years yield of 3.2%. While dividend yields and bond yields don’t necessarily have to be compared directly, VFH is invested in largely mature industries, and so the higher the delta here (in favor of risk-free bond yields), the more expensive funds as VFH appear (at least intuitively speaking).
The main issue I have with VFH right now is where we are in the cycle. VFH has done well due to rising inflationary pressures, and rates have risen in line with inflation rates (but not proportionally), which generally supports lender (financial institution in which VFH invests) margins. However, VFH is also another form of beta, given the breadth of its portfolio. Year-to-date, the US S&P 500 stock index has fallen -18.19%, while VFH has fallen -17.23%. The quinquennium beta for VFH is about 1.23x. The fact is that VFH is not a safe haven in the current macroeconomic or market environment.
In addition, inflationary pressures will eventually subside, we may well have a recession of some kind, and in any case yields should peak. VFH is therefore likely to face some headwinds, and so I imagine the “down beta” will exceed any “up beta”. Additionally, the rates and financials narrative described above hasn’t exactly held up in 2022. Outflows have been strong and consistent over the past year or so.
Since uncapped VFH’s benchmark is not materially different from the capped version, we can use the data available from the former to assess VFH’s valuation relative to the current price of $80.84 per share at the time of writing. The benchmark shows, as of July 29, 2022 (admittedly slightly outdated as of this writing), trailing and forward price-to-earnings ratios of 10.69x and 11.63x, respectively. So ‘post covid’ earnings are still on track to be lower for financials, which makes sense given the lending boom during the ‘covid period’, hence the higher forward price to earnings ratio than its trailing counterpart. However, the implied expected return on equity is still strong at over 12%.
Assuming return on equity remains at least 10% over the next several years, five-year earnings growth (including the projected one-year decline of about 8%) would be about 1. 3% per year. This is low, most likely below inflation (unless we get sudden deflationary pressures; a complete reversal of the current situation). Still, we can at least start with this conservative estimate. Assessing VFH on its total earnings potential on this earnings outlook, I arrive at an implied equity risk premium of around 8-9%.
By reducing the implied ERP by the 1.23x beta of VFH, the ERP could be closer to 7.2%, which is still high. This also uses a somewhat arbitrary risk-free rate of 4% (the current 10-year yield), as mentioned, is lower, at 3.2%. I am cautious and I add a surplus in the event of a new take-off over 10 years. I think part of the problem is that as the economic cycle matures, the demand for loans will fall and the risks for lenders will increase. We could see explosions, which could affect the profits of insurance companies. There are all sorts of pockets of risk that can explode in recessions. Financials are more risky; they crashed hard in 2007/08, and we saw a repeat of that in March 2020 (VFH fell harder than the broader equity indices).
We are also seeing various yield curve inversions on the US yield curve at the moment, and even the 20-year to 2-year gap reversed briefly in August. I actually think we’ll see more of that. For example, the R* interest rate (essentially, the US central bank interest rate at which the economy is likely to move in a stable manner; with respect to growth, inflation, unemployment, etc.) is less than 0.5% (see here). Long-term inflation, if the long-term past (driven by long-term supply factors, demographics, etc.) is any indication (and it usually is), should not exceed 3% . Thus, the 20-year US rate should probably settle at around 0.5% + 2.5-3%, or 3-3.5%. It is currently 3.6%.
Meanwhile, in the short term, when inflationary pressures are high, the Federal Reserve is raising rates. This month, September 19, 2022, the Fed is due to meet again and will (in my opinion) probably go for another 75 basis point hike (75 instead of less, given that it’s on the table , and the long-term risks to the economy from persistently high inflation are too high to ignore). This would bring the Fed rate to around 3.25%, close to our 20-year yield range. And a recession is likely to depress growth and inflation expectations, which should put pressure on long-term yields (hence the likelihood of another reversal). In any case, the long-term yield spreads are marginal and will likely remain so, which is negative for VFH (financial stocks). The 10-year/2-year spread, as shown below, remains inverted.
According to Fidelity research, only China is expected to see higher bond yields over the medium term, given that it leads the pack in terms of its current economic cycle (as of Q3 2022).
The United States, Canada, the United Kingdom and the Eurozone are all major economies that are likely to experience a recession in the medium term. The stock market generally drives the economy, but more recently (likely due to greater “financialization” and greater participation in the stock market) the stock market has become less of an abstraction. If the stock market is art and the real economy is life, life imitates art. The weaker the market, the more we will see a recession, and it would seem that it would be in the interest of the main central banks given the inflationary pressures.
I reiterate this point: another 75 basis point hike is likely this month, from the Fed. A lower stock market is almost an extension of monetary policy at this point. And with QT draining liquidity from the system, I’m not optimistic about banks’ ability to outperform the broader markets at this point. Based on my basic valuation gauge, VFH does not look expensive, but is priced for a risky short-term period; expect strong returns if inflationary pressures abate quickly without a major recession, but in all other cases, the high equity risk premium may well turn out to be fair.