Main Thesis / Background
The purpose of this article is to evaluate the SPDR S&P Regional Banking ETF (NYSEARCA:KRE) as an investment option at its current market price. It is a fund with a objective to “provide investment results that, before fees and expenses, generally correspond to the total return performance of the S&P Regional Banks Select Industry Index”. I last covered KRE about five months ago, when I slapped a holding rating on the fund. In retrospect, this was a well-founded prospect, as KRE’s comeback since then has been mostly flat:
With the markets seeing high volatility so far in 2022, I wanted to take another look at KRE to see if I should change my rating. Upon review, I believe a more bullish/buy rating is warranted for several reasons. First, regional banks are priced attractively, as is the financial sector as a whole when looking at valuations relative to the broader market. Second, regional banks are less exposed to foreign revenue streams, making them attractive in an environment where geopolitical risks dominate the headlines. Third, the Fed’s rate hike cycle, which is in line with other central banks around the world, will provide a tailwind to lenders and financial institutions.
Why consider banks in this climate?
To begin, I want to address a few key points as to why readers may want to consider banks/financial stocks more broadly. This is relevant to KRE, but also to the myriad other ways investors can play in this space. The first is valuation. While most sectors are still posting P/Es above the five-year average (indicating stocks are a bit pricey), the financial services sector remains competitive. For comparison, note that financials have a lower PER than all other sectors except energy:
Of course, that doesn’t necessarily mean the sector will outperform, or even produce a positive return. But that should reassure investors, given the rat race we’ve seen recently.
Another bright spot for KRE and most bank funds is that the Fed has started its rate hike cycle. Last week, the Fed announced a 0.25 basis point hike, the first since 2018. to continue raising rates throughout 2022. In fact, according to the current dot plot, the Fed expects to end the year with rates in the 1.75% to 2.5% range, as shown below :
Ultimately, this is a positive for credit issuers and other lenders. Rates charged will rise accordingly, and this usually happens at a faster rate than rates on deposits and savings. The end result is a net gain in profit and interest margins, which provides a tailwind to earnings for the underlying companies in the year ahead.
Regional banks are primarily US-focused
I will now move on to KRE, and regional banks, specifically. When reviewing this particular fund, readers should note that this is a bank-only ETF. Yet, unlike many popular banking/financial ETFs, it excludes the biggest names in banking. These mega-banks dominate the broad market and financial ETFs, so I consider KRE a good diversifier to start with. Moreover, it is not “top heavy”, with the top holding accounting for less than 3% of the fund’s total assets. Beyond that, readers can see that his list of holdings is filled with companies that generate the vast majority (if not all) of these revenues and profits domestically:
I mention it now because I think it is particularly timely to assess its exposure to international and foreign sources of income. Now, I want to reiterate that I don’t think foreign exposure is inherently bad or bad, but investors just need to manage their risk and be careful in this environment. Although returns can be higher by taking on more risk, this may not be for everyone, so invest accordingly.
In that vein, I think this is a particularly relevant time to consider how exposed his portfolio is to broader international geopolitical concerns. Although the banking sector is not heavily exposed to Russia, the largest US banks are exposed to it. The current crisis in Ukraine is causing many institutions, within banking and other sectors, to rethink their exposure to Russia and Eastern Europe as a whole. For now, the situation has been mostly confined to this region, but there is no guarantee that this will remain the case.
The good news for US investors is that the banks and economies most exposed to Russia are, unsurprisingly, in Eastern, Southern and Central Europe. But, again, that doesn’t mean the US doesn’t have one. Although the exposure is not substantial when we look at banks’ balance sheets as a whole, we find that there is some exposure. The important point to note is that this relies on the big US banks (think JPMorgan Chase (JPM) and others), there is a risk of contagion if this conflict spreads more widely across Europe:
The takeout here is simple. Regional banks are less exposed to sell-off risk related to geopolitical events. Their fortunes are not tied to Europe, Russia, or any other region outside of the United States, for the most part. With the past few months being a stark reminder of the risks involved in international investing, a fund like KRE might be just what some readers are looking for.
Growth through mergers
Another positive factor for the wider regional banking sector has been the sharp increase in mergers and acquisitions in recent years. Last year was a particularly important year for M&A activity, which led to record deals, in terms of size:
There are several positives to this. First, it creates synergies and scale, allowing these institutions to better compete with large megabanks. Second, it leads to cost reductions for the combined institution. One of the newly merged bank’s top priorities is to start reducing the number of branches, which has been an ongoing trend for years, accelerated by both the mergers and the pandemic. This leads to a sharp reduction in operating expenses. Third, the bank being acquired is usually bought out at a premium to the market share price. This amplifies the returns for the shareholders of the acquired company.
To manage expectations, readers should note that 2021 was a banner year for regional bank mergers and acquisitions, and it is unlikely to continue at this pace. Still, the trend for the sector is strong and is likely to continue at least to some extent in 2022 as well. Furthermore, even if mergers and acquisitions slow down, which is expected, the newly merged banks that have emerged from the past two years of mergers and acquisitions have likely become stronger and more competitive institutions. All of these factors combine to give me some confidence that a fund like KRE will have a reasonably strong year.
The S&P 500 remains the heaviest
My final point is about why I like getting into funds like KRE, instead of just adding more money to my S&P 500 ETFs. Yes, the S&P 500 has a strong track record and it will continue to be a good part of my portfolio. However, since I was invested, the S&P 500 has become increasingly concentrated. Specifically, the tech weighting within the index has increased, and it has also been amplified by its overreliance on just a handful of names. In fact, if we look back over the last six to seven years, we find that the S&P 500 is far more concentrated:
The thinking here is broad. Investors may well be more creative with their exposure to ETFs. This overreliance within the S&P 500 is one of the main reasons I own sectors such as Utilities, Value Stocks, Casinos/Gaming, Retail, and most importantly, Banks/Financials. In truth, the dominance of the S&P 500 by a handful of companies favors entry into any of the sectors or themes I mentioned above, not just regional banks or KRE. But, as I mentioned, I see a few catalysts for KRE individually that are worth considering. When I couple this with the desire to expand beyond the standard US index, the bullish case becomes even clearer.
At the end of the line
The fall in the market and the subsequent rebound caught many investors off guard at the start of the year. That said, many geopolitical risks remain, the rate hike cycle has started in the US and consumer confidence remains gloomy. This underscores the need for investors to remain diversified – whether in foreign equities versus domestic equities, equities versus bonds, or by addressing sector themes that may be underrepresented in their portfolio. KRE is a good way to play this concept, as it holds companies that are very underweight to the S&P 500 (or not included at all). Additionally, while the Fed’s rate hike may be a headwind for the broader market, it should be a positive catalyst for KRE and other bank funds. The fund has seen a slight decline since the start of 2022, and that suggests to me that now is a reasonable time to start buying. Accordingly, I may be initiating a position in this fund and suggest readers consider the idea at this time.