2023-05-05 06:11:39 ET
Summary
- It is often when financial markets become overwhelmed by fear that some of the best opportunities can be found. And the SPDR S&P Regional Banking ETF is becoming too cheap to ignore.
- The recent plunge in KRE's price seems increasingly difficult to justify even after factoring in risks of a few more bank failures in the coming months.
- KRE is trading at just 6.5x forward P/E. Even after factoring in a 50% plunge in future earnings, investing in KRE is still way cheaper than investing in the SPY.
- By being more selective and investing more aggressively following deep and sharp sell-offs, value investors may be able to pick up shares at much deeper discounts to valuations.
- We initiate our coverage of KRE with a "Strong Buy" rating.
In the business of investing, it is often when financial markets become overwhelmed by fear that some of the best opportunities can be found. Recent bank failures have spooked investors into dumping shares of U.S. regional banks that the SPDR S&P Regional Banking ETF ( KRE ) is becoming too cheap to ignore.
We understand that the foundation of the modern fractional reserve banking system is built upon the fragile confidence that depositors are unlikely to withdraw their deposits all at once. We are also aware of the possibility that recent bank failures may just be the tip of the iceberg. A long history of bank runs and financial crises that have repeatedly threatened to destroy the fractional reserve banking system every decade or two, also serves as a reminder of the system's inherent flaws and fragility.
But regardless of the potential risks - which by definition are uncertain - there must be a price at which investors are adequately compensated for bearing the risk of loss. The same applies to "low-risk" or "investment grade" assets: there must be a price at which rational investors would decline to pay, regardless of the potential. The fact that every economic scenario is subjected to some level of uncertainty and that even the most experienced of economists regularly get their predictions wrong, means that investors should consider an investment whenever its price has moved beyond the boundaries of reason.
We certainly think that the recent plunge in KRE's price seems increasingly difficult to justify even after factoring in risks of a few more bank failures in the coming months.
Valuations Are Compelling, Even If This Is 2008 Again
Let us first try to rationalise the sell-off in KRE in terms of valuations. At the time of writing, KRE was trading at $36.08 and had fallen by around -54% from its all-time peak of $78.81 recorded on 14 January 2022. This decline is analogous to half of the 143 regional banks in KRE's portfolio being wiped out completely, while only the other half will survive the crisis. The current tally for bank failures in the U.S. stands at just 3 (Silicon Valley Bank, Signature Bank, and First Republic). Sure, there is a possibility that more bank failures could be in store in the coming months. But current conditions remain in stark contrast to the onset of the 2008 Global Financial Crisis.
In terms of multiples, KRE is trading at just 6.5x Forward P/E and 0.81x P/B as of 3 May according to fund information provided by State Street Global Advisors. Investing at current valuations essentially means that even if earnings across the U.S. regional banking sector were to plunge by 50%, an investor would be paying for KRE at 13x P/E and 1.6x P/B. Even after factoring in a 50% plunge in future earnings, investing in KRE is still way cheaper compared to investing in the SPDR S&P 500 ETF Trust ( SPY ) , which is trading at 18.6x P/E and 3.7x P/B .
Another way to think of valuations is to imagine that we could travel back in time to the onset of the 2008 Global Financial Crisis and decide if we would invest in KRE then. Of course in hindsight, we would jump at the opportunity to buy KRE at a -54% discount and ride the 11-year bull market that followed netting a cumulative gain of around 181% over the period.
The decision to invest is easy not just because we have the benefit of hindsight, but also because we are not subjected to the pessimism that was propagated by the financial media and the perma-bears then.
Sentiment Can't Get Any Worse
That same psychology is once again holding back investors today. The vast majority of economists on Wall Street are calling for a recession and consumer sentiment is once again at historic lows.
Many investors are choosing to wait it out, hoping that there will be a better time to get in. Perhaps when there is some evidence that the worst is over. But we argue that financial markets tend to be forward-looking. By the time investors get more comfortable and confident with KRE's outlook, prices would have already rebounded substantially from the lows. Buying late means not only missing out on returns but could also mean assuming greater downside risk since prices are much higher than before. The common mistake of buying late is usually a side effect of market timing and is counterintuitive to value investing.
Based on the principles of value investing, one should buy so long as prices have fallen below what would be considered fair valuation. What is fair valuation however is debatable, and this is where investors find themselves being lured into thinking that it might pay to wait just a little longer. The thinking goes... "Surely if the majority agrees that more banks could fail in the near term, then it is better to wait it out." Unfortunately, buyers of KRE are certainly aware of that too, and all the risks that are known may have already been factored into the current price.
But What If We Are Wrong?
One of the biggest advantages of long-only value investors is that they can hold onto their positions for as long as needed for prices to catch up to fair value. Of course, nothing is certain. Fundamentals could change over time, and challenges in estimating fair value could undermine the success of value investing. But in comparison to short-term traders who are attempting to catch the absolute bottom by forming opinions based on reports propagated by the financial media, the odds should favour value investors. Besides, is catching the market bottom even necessary? Even some of the most successful investors including Warren Buffett, are known to miss market bottoms throughout their long investing careers. So why are investors trying so hard to outdo the best?
Another advantage that value investors may employ to further enhance their odds of success is to be much more patient and selective. Various studies have shown that stock markets tend to overreact, resulting in prices that regularly overshoot both on the upside and downside. However, because of loss aversion bias , the urgency to dump shares to avoid a loss is much greater than the urgency to buy. Thus, stock market sell-offs also tend to be much quicker and overshoot more compared to rallies. By being more selective and investing more aggressively following deep and sharp sell-offs, value investors may be able to pick up shares at much deeper discounts to valuations. Needless to say, we see the recent sell-off in KRE as an ideal opportunity to initiate a long position.
Technicals Are Bearish, Be Prepared To Ride It Through
Ideally, we would like to see the technicals align with our bullish view on KRE. However, we are getting a mixed picture based on Fibonacci retracement levels.
As the accompanying chart shows, the panic selling in KRE looks exhausted at current levels, with the sell-off stopping just short of penetrating the key Fibonacci retracement level of 78.6% at the close on 3 May. Although the last trading session saw the KRE break below this key level and drifted even lower intraday, the break seemed indecisive as prices eventually recovered quite significantly. Overall, technicals are bearish and we would not be surprised to see further selling pressure ahead, which could potentially see the KRE retest its 2020 lows.
Despite the technical downside risk we have just highlighted, we are nonetheless convinced that risk-reward remains compelling given that the magnitude of a potential rebound in KRE could be multiple times that of the downside.
In Conclusion
Our long-held fundamental view of the U.S. economy translates to a base-case scenario for a mild recession and cooling inflation, which should encourage the Fed to consider easing monetary policy with a rate cut potentially by the end of the year.
Although we acknowledge that confidence in the U.S. banking system is likely to remain volatile in the coming months, we do not expect a widespread contagion of bank failures. Further bank runs are likely to remain confined to mismanaged banks with overly concentrated exposures, and we think that the sharp decline in KRE has more than adequately adjusted for these risks.
We initiate our coverage of KRE with a "Strong Buy" rating.
For further details see:
KRE: Too Much Fear, Too Cheap To Ignore