We are firm believers at Prospector that active management should not begin with a benchmark. Our bottom-up approach to portfolio construction and our focus on areas of the market where we possess competitive advantages generally produce stock and sector allocations in our portfolios that differ significantly from the weightings in the S&P 500. By not being a slave to a benchmark and emphasizing the unglamorous sectors we know best, we have shown our disciplined process can generate alpha across market cycles.
One sector we pay particularly close attention to, despite its diminished role in the S&P 500 since the Great Financial Crisis, is financials. Today, financials represent 12% of the S&P 500, far below its 20%+ share of the index in the early 2000s (source). The top 10 financials stocks, primarily the money centers, now account for over 50% of the sector. This concentration presents a large opportunity set of smaller, under-the-radar stocks which we feel are more prone to being mis-priced.
Financial Select Sector SPDR Fund (XLF): Top Holdings
Source: YCharts
Many of our best ideas come from our deep analysis of smaller regional banks. Unlike the money centers, regional banks have less exposure to market making activities, esoteric assets, complicated derivatives, and other business lines which do not lend themselves well to fundamental analysis. Furthermore, large banks are more exposed to systemic risk than their smaller competitors given their broad geographic exposure, which often extends to international markets. While our investment universe includes banks of all sizes, we’ve found that those operating in specific geographies with robust local economies are often more compelling investments due to their idiosyncratic risk characteristics.
We also have a strong preference for banks with strong balance sheets and clean credit profiles. We assess this not only from a close reading of GAAP and SEC filings, but also scrutiny of information included in other regulatory filings, including Call Reports filed with the FDIC and Financial Statements filed with the Federal Reserve, to gain additional insight into loan and deposit composition. In order to mitigate downside risk, we aim to avoid exposure to loan categories like speculative construction and development, retail commercial real estate, non-owner occupied commercial real estate and subprime consumer loans.
“Over twenty-plus years we have proven we can manage the downside, even when overweight financials,” said Prospector Founder John Gillespie. “We’ve done this by focusing on low leverage, well-capitalized companies.”
Another key consideration in our evaluation of regional banks is the potential for M&A. We believe the consolidation trend among small- and mid-size banks is still in its early stages. After all, the U.S. is still home to a staggering ~4,200 independent FDIC-insured banks and 72,000 branches (source). As digital banking becomes the norm for most consumers, we expect smaller banks will continue to pursue mergers to gain scale and realize cost synergies to enable further investments in their digital platforms. Acquisitions can also build inroads into other profitable business lines such as wealth management. When researching regional banks, we create detailed financial models to determine private market values based on simulated M&A scenarios, and then attempt to identify likely acquirers.
Financials have always been an area of focus for Prospector given our team’s extensive background working in the financial sector. The sector, however, is not the monolithic, cyclical structure that concentrated indices make it out to be. Indeed, a variety of concerns can fall under the heading of “financials,” many of which are overlooked. In our next blog, we’ll turn to another underrepresented component of the financial sector, insurance companies, where superior investment opportunities can also be uncovered.
