If you’ve been steering clear of financial stocks lately, that’s certainly an understandable decision. Just as last year’s rising interest rates made lending a more profitable business, the interest rate cuts expected later this year could re-crimp lending’s profitability. Loan delinquencies are on the rise as well. Both work against companies in the money business, as does the occasional lingering hint of economic lethargy. The relatively poor performance of most financial stocks since early last year suggests investors see this sector’s unique risks.
In a few too many cases, though, the sellers have overshot their target. That is to say that several financial stocks have become oddly cheap within the past few months, pricing in far more worry than is merited. If you can stomach the volatility they’re sure to continue dishing out for the foreseeable future, three of these names may be worth taking a shot on here.
1. Ally Financial
Ally Financial (ALLY -2.25%) is an online-only bank. Don’t let its lack of a brick-and-mortar presence fool you, though. The company offers all the services you’d expect from any traditional bank, including checking and savings accounts, credit cards, investing, and a wide array of loans. The bulk of its bottom line, however, is lending, and car loans in particular. Not counting corporate-level write-downs, more than 80% of last year’s pre-tax income came from the automobile industry, with more than two-thirds of it being driven by auto financing alone.
That was an incredibly fortunate business mix in 2021 and then again in 2023, when demand for new cars was huge. As noted, however, cracks are starting to show. At the same time, demand for new vehicles is waning, and past borrowers are now falling behind on their payments. The U.S. Federal Reserve reports that as of the fourth quarter of last year, 2.66% of the United States’ automobile loans are now 90 days or more behind. That’s not only up from 2.22% a year earlier, but it’s pushing past pre-pandemic levels when the economy was at least in decent shape.
And Ally is showing signs of this struggle. Last year’s loan-loss provision of nearly $2 billion is well up from the prior year’s figure of $1.4 billion. Its delinquencies are rising, too, pushing its charge-off rate from 1.16% of its total loan portfolio in the final quarter of 2022 up to 1.77% in the final quarter of last year.
The thing is, on balance, these metrics actually aren’t all that bad.
They’re not likely to get much worse either, in light of last quarter’s surprisingly strong GDP growth of 4.9% and last month’s similarly strong U.S. job growth of 353,000 new positions. These numbers suggest the economy is easing into a so-called “soft landing” before starting a more sustained expansion instead of making a hard landing that just plain hurts. That’s good for Ally Financial, but it’s even better for Ally shares that are priced at only 11 times this year’s consensus per-share profit estimate.
2. U.S. Bancorp
It’s another bank, but U.S. Bancorp (USB -0.14%) is considerably different from Ally. While U.S. Bank does offer a variety of online and app-based banking services, its roots are brick-and-mortar branches. It operates over 2,000 of them in 26 states, employing more than 75,000 people. All told, it boasts more than $600 billion in assets. That’s big … except it’s not nearly as big as the likes of JPMorgan Chase or Bank of America, both of which are tending to more than $2 trillion worth of assets.
This smaller size could be seen as a liability, and in some ways, it is. It may prevent U.S. Bancorp from venturing into lucrative markets. The capital markets business comes to mind. While the company does provide basic investment and wealth-management services, it’s not really a player when it comes to underwriting stocks or managing a commission-generating trading business.
In other ways, though, this regional bank’s smaller size leaves it nimbler than its bigger banking rivals, allowing it to do things lots of other banks don’t. Take its payment services arm as an example. Credit cards, corporate payments, and merchant processing accounted for roughly 40% of last year’s non-interest income. These businesses’ bottom lines are considerably more predictable and consistent than those tethered to interest rates are.
Perhaps the chief reason to step into U.S. Bancorp shares now that they’re trading at a mere 10 times this year’s expected earnings, however, is a less evident one. This bank just has a history of smart, conservative self-management. The dividend yield of just under 5% isn’t too shabby, either.
3. Ares Capital
Last, but not least, consider jumping into a stake in Ares Capital (ARCC -0.10%) while its dividend yield stands at a frothy 9.5% and shares are priced at less than 9 times their trailing and forward-looking profits.
Those juicy numbers come with an important footnote, of course.
Ares Capital shares may be a conventional stock, but this isn’t a conventional company. It’s categorized as a business development company (BDC), which, as the name suggests, helps businesses grow. It provides capital to smaller enterprises that may not want or be able to secure a bank loan, but that also don’t want to issue stock to raise funds. This funding can be supplied in exchange for equity in the company in question, but it’s usually in the form of a loan. The interest rates on these loans are typically higher than market-based rates, reflecting their above-average risk. It’s worth these terms to both the borrower and the lender, though. It’s also worth the risk to BDC shareholders, as these stocks tend to generate above-average dividend payments.
Investors keeping close tabs on Ares Capital may already know the past four years have proved complicated for the company. First, the COVID-19 pandemic disrupted most of its borrowers’ businesses, and then the recent shake-up of interest rates has set the BDC business on its ear. These organizations generally rely on short-term funding that costs less than the long-term interest rates they’re charging. With the yield curve outright turning upside down in the middle of 2022, however, a key aspect of Ares Capital’s business model has been rattled. Revenue and earnings have been just as shaken up.
ARCC Revenue (Quarterly) data by YCharts
There’s a light at the end of the tunnel, though. That is, interest rates are slowly but surely easing their way back to normal, and the economy is seemingly healing without suffering the aforementioned “hard landing” that an inverted yield curve usually indicates is in the cards.
It’s not the kind of pick that’s right for everyone, and even if it is right for you, it probably shouldn’t be the centerpiece of your holdings. Between the stock’s low price, its big dividend, and a slow-churning economic recovery on the horizon, however, Ares Capital could certainly be worth considering as an addition to your portfolio.
