VFH - VFH: Low Contagion Risk And Earnings Growth Could Drive Shares Higher

2023-06-16 09:46:53 ET

Summary

• Vanguard Financials Index Fund ETF Shares may be the right choice for investors looking to capitalize on the recent volatility in the financial sector.
• The financial sector is expected to record robust earnings and revenue growth in 2023 and 2024, which could contribute to enhancing investor confidence.
• In addition to a solid dividend yield and low expense ratio, investing in ETFs like VFH provides diversification and risk mitigation compared to single-stock investments.

The share price of Vanguard Financials Index Fund ETF Shares ( VFH ) recovered some of their recent losses as contagion risk decreased significantly. The recovery appears to be on solid ground, owing to improvements in fundamental factors such as dwindling chances of a recession and a pause in rate hikes. Furthermore, the sector's ability to boost earnings would almost certainly help shares maintain their traction in the second half. As a result, now may be the best time for long-term investors to capitalize on the recent drop in financial stock prices. With a dividend yield of more than 2.40% and a greater diversification, the Vanguard Financials ETF may be the best choice for long-term investors looking to minimize risk and maximize gains when compared to a single-stock investment.

Contagion Risk Eases

Contagion risk was extremely high following the failure of regional banks in the first quarter because markets were concerned that waning confidence and liquidity problems could cause the collapse of the entire financial sector. Fortunately, the risk has decreased since the Fed launched a Bank Term Funding Program (BTFP) to aid the liquidity of struggling regional banks. Furthermore, the factors that increased contagion risk, such as deposit flight and losses on bank-held fixed-income securities, are likely to improve in the coming quarter.

For example, a trend of deposit flights has begun to reverse in recent weeks, thanks to the announcement of higher deposit rates from regional and large banks. According to FRED data , deposits at all commercial banks bounced back from recent lows and are currently standing at the highest level in the last two months. In an effort to stop the outflows, a large number of lenders started offering a nearly 5% yield on CDs maturing in around a year. In addition, several other initiatives such as a big bonus for a new savings account opening and additional rewards for holding them a long time are helping in attracting deposits. The Fed's pivot could also help lower the flight of deposits toward money markets. In the past few quarters, the Fed’s rate hike policy has shifted investor focus toward money markets where yields are higher on instruments with short maturities. Although money market instruments look attractive for the short term, investors are likely to lose the lure of high yield because rates have almost peaked with high expectations for only one more rate hike in 2023 and a cut to begin in early 2024.

Revenue and Earnings Growth Power

Earnings growth has always been a major factor influencing share price growth. The financial sector as a whole has benefited from higher interest rates, with the exception of regional banks and a few other small lenders, which make up a very small portion of the sector. According to FactSet data , the sector is anticipated to record a 10% earnings growth and 8% revenue growth in 2023, followed by slightly slower revenue growth and nearly double-digit earnings growth in 2024.

The most recent earnings results from VFH's top ten holdings also point to the sector's strong growth trends. For example, JPMorgan Chase ( JPM ), the largest US bank, not only outperformed analyst expectations in the first quarter but also raised full-year projections. JPMorgan now expects total net interest income for the year to be $81 billion, up from $73 billion previously. Its earnings forecast for 2023 represents a whopping 20% increase over the previous year. Similarly, Bank of America's ( BAC ) first-quarter earnings per share of $0.94, which exceeded the average analyst estimate of $0.83, also increased from $0.85 in the fourth quarter of 2022 and $0.80 in the previous year. Despite challenges in the consumer banking and investment segments, Wall Street expects other large banks such as Wells Fargo ( WFC ) and Goldman Sachs ( GS ) to produce high single-digit earnings growth in 2023.

Consumer finance companies also continue to profit from higher rates even though provision for credit losses has been hurting their earnings growth. For instance, American Express ( AXP ) reaffirmed its full-year double-digit EPS growth guidance on 15%-17% revenue growth. The Financials sector is anticipated to have the highest year-over-year revenue growth and third-best earning growth rate of all eleven sectors in 2023.

Valuations and Quant Ratings

Of the eleven S&P 500 sectors, the financial sector has the lowest forward PE at 12.5, which also represents a significant drop from the average of 18.5. Although a low forward P/E does not always indicate a good time to buy, it does in the financial sector. This is due to the strong growth in expected earnings over the current price. The diversified banks, which account for approximately 23% of VFH's portfolio, are trading at a significant discount based on their 8.4 times forward earnings. The consumer finance segment is also trading at significantly lower forward earnings than the sector average.

Due to a high-risk factor and slower share price momentum, VFH received a lower quant score and a hold rating. Despite this, the momentum grade has improved significantly when compared to the previous three and six months. Since earnings growth and fundamental factors are likely to increase investor confidence in the financial sector, I anticipate further improvement in the momentum score in the upcoming months.

A high liquidity factor score also indicates greater overall market interest in the ETF. Its average trading volume over the last three months has been around 589.38K, which is significantly higher than the 40.27K median for all ETFs. The ETF's expense ratio of 0.10% is also significantly lower than the all ETFs average of 0.49%. Its closest competitor, the iShares U.S. Financials ETF ( IYF ), has an expense ratio of 0.39%. Expenses always have an effect on overall returns, especially when investing for the long term. The dividend factor, which also has a significant long-term impact on total returns, received an A grade. This is because its dividend yield of 2.40% is higher than the all ETFs median of 2.2% and up from the S&P 500's average of around 1.50%. Although VFH ETF's yield is lower than what treasuries are offering right now, it still looks better to buy a 2.4% yielding ETF when you are expecting a healthy share price appreciation in the long term. Moreover, as earnings growth trends are strong in the financial sector, there is a low risk to VFH's dividends in 2023 in my view.

Risk Factors to Consider

Even though CME data suggests only one more rate hike in the remaining months of 2023, things could get worse if the Fed puts more pressure on the financial sector by raising rates a few more times than expected. Rate increases may also have a negative effect on deposits at commercial banks because yield-seeking investors find money markets more alluring. On the other hand, banks' strategy of offering higher deposit rates to stem outflows may have a negative impact on profit margins.

In Conclusion

Although I anticipate a recovery in the second half of the year and a continuation of the momentum in the following year, there are a number of risk factors that could cause volatility in financial stocks. Therefore, investing in ETFs such as VFH, which provide significant diversification and broader sector coverage, would be an excellent risk-mitigation strategy when compared to single-stock investment. Overall, its solid dividend yield, low expense ratio, and greater diversification make it an ideal long-term ETF.

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