Smaller Financial Stocks Get Their Grooves Back

Nearly halfway through 2021, some themes are crystalizing. Among the more obvious at the equity level are the leadership of value stocks, small caps benefiting from cyclical tailwinds and the financial services sector being the second-best performing group in the S&P 500 behind only energy thanks to lengthy run higher by 10-year Treasury yields.

Put it all together and it's also clear a perfect storm brewed for small-cap value. Of course, part of the dog wagging that tail is bank stocks, both of the mid- and small-cap varieties. For clients that need or want smaller stock exposure, this is a conversation where advisors can add value because, as is usually the case, it's the big money center banks and the related large-cap strategies that are stealing all the bank stock thunder this year.

“While the headlines are focused on the megabanks, investors would be wise not to forget about mid- and small-cap financial companies,” writes ProShares Global Chief Investment Strategist Simeon Hyman. So far this year, mid- and small-cap financials are nearly keeping up with their large-cap siblings while trading at a notable discount.

Good Deals to Be Had

Indeed, smaller financial stocks trade at discounts to their large-cap peers, which is a pleasant surprise because even smaller value fare usually trades at premiums to its large-cap counterparts. The S&P Large-Cap Financial Index trades at 16.88x earnings compared to 14.42x and 12.22x, respectively, for the equivalent mid- and small-cap indexes.

On the basis of return on equity (ROE), mid-cap financials are slightly ahead of their large-cap peers while smaller bank stocks are behind the two larger groups. Acknowledging that the value rally may still be in its early innings is, of course, a catalyst for smaller bank stocks. So is the idea that 10-year yields may have more runway to the upside after cooling off in recent weeks.

“With interest rates likely to continue to rise and an improving economy boosting activity levels and keeping a lid on loan losses, mid- and small-cap financial sector companies may have more room to run,” adds Hyman.

Consolidation should be added to the list of factors with the potential to drive smaller bank equities higher. Loan growth was slowing even before the coronavirus pandemic and with interest rates still low, it's efficient for suitors to boost deposits and loan books via acquisition and the mid- and small-cap arenas are the perfect places to do just that.

Getting Paid to Get Involved

With inflation at the forefront of so many clients' minds these days, an easy, effective strategy for advisors to convey to the concerned is dividend growth. Prosaic as it may seem, it's been an inflation beater for decades. When it comes to payout growth, smaller bank stocks have plenty of it.

“As it turns out, there are a good number of mid- and small-cap financials that have been able to consistently grow their dividends, many of them through the great financial crisis,” says Hyman.

Consider the following. The Russell 2000® Dividend Growth Index, which mandates that member firms have a minimum dividend increase streak of 10 years, devotes 24.30% of its weight to bank stocks – its largest sector allocation. The S&P MidCap 400® Dividend Aristocrats® Index, which requires a 15-year payout increase streak for admittance, has a 27% weight to financials, its second-largest sector exposure.

Bottom line: Smaller can be beautiful with bank stocks and that sentiment is already proving to be accurate.

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