Hockey legend Wayne Gretzky coined the phrase now co-opted by every money manager in the racket: "I skate to where the puck is going to be, not where it has been." Now, the Trump administration's proposed tax reform plan may just give them the opportunity to prove it.
One sector in particular is poised to capitalize on the anticipated 43% reduction in federal taxes. After muddling through the post-financial crisis landscape, U.S. commercial banks are starting to show signs of life. The return to profitability will ultimately lead to renewed merger and acquisition (M&A) activity. This chart from the always resourceful Saint Louis Fed paints a clear picture of the market.
While the number of U.S. commercial banks has been shrinking over the past 30 years, the level of total assets held by commercial banks has ballooned. Eventually, that money will have to go somewhere. If current trends are any indication, much of it will end up going towards acquisitions.
One of the best ways for investors to position themselves for a bank merger bonanza is the John Hancock Financial Opportunities Fund (NYSE: BTO). Launched in 1994, the closed-end fund (CEF), originally named the John Hancock Bank and Thrift Opportunities Fund, rode the wave of regional bank consolidation of the mid 90s and early 2000s. After pulling back during the financial crisis of 2008, the fund has shot up from its 2009 lows. Last year, the fund returned a mind boggling 40%.
The First Trust Specialty Finance and Financial Opportunities Fund (NYSE: FGB) is CEF that's probably due for a rebadge. The term "specialty finance company" is an outmoded term for entities now known as business development companies (BDCs). BDCs rose to prominence in the aftermath of the 2008 financial crisis when they became the nation's small- to mid-market business lender after commercial banks backed away.
Often, BDC loans are structured with an equity component. In the event the borrowing company is sold or taken public, the lender's ownership stake can juice up the BDCs total return. FGB's manager uses a value-focused strategy, buying up shares of BDCs, REITs, and other financial companies at bargain prices.
Favorable corporate tax rates will encourage acquisitions of small- and mid-sized businesses in the private space. This should in turn boost returns and share prices for the BDC sector. At $6.94, shares trade at an 18% discount to their 52-week high and throw off a compelling 10.1% yield.
The PowerShares KBW High Dividend Yield Portfolio Exchange-Traded Fund (Nasdaq: KBWD) tracks an index based on the KBW Nasdaq Financial Sector Dividend Yield Index. While nearly 37% of the fund is allocated to mortgage REITs, a full 50% of the portfolio consists of asset managers, investment banks, brokers, and regional banks. Again, lower corporate taxes and anticipated relaxed financial industry regulations could result in sector consolidation. The average P/E ratio for stocks in this portfolio is just under 13, a bargain level by any standard. Shares also carry an 8.3% dividend yield.
Risks To Consider: While everyone seems excited by the prospect of a much-needed corporate tax overhaul, the Trump administration's legislative success has been dismal. It may take a while to pass significant reform. Also, many of the stocks held by these funds are not the bulge bracket financials such as Citigroup (NYSE: C) or J.P. Morgan Chase (NYSE: JPM). Given the right environment things will happen, but again, these things take time.
Lastly, on a macro scale, the Fed continues to unwind post-crisis through gradual rate hikes and shrinking its balance sheet. Interest rates are still in the crosshairs, creating further uncertainty.
Action To Take: As a basket, these three funds kick out a handsome 7.4% dividend yield. Patient investors interested in capitalizing on improved earnings and consolidation in the financial services sector will be paid well to wait for results. Typically, financial services company mergers are priced in the neighborhood of 2.5 times book value. This could mean total returns in excess of 25% in some cases.
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