Financial Services ETFs: Buyback Benefits?

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The Financial Select Sector SPDR (NYSEArca: XLF), the largest exchange traded fund tracking the financial services sector, and rival financial services ETFs have previously been highlighted as beneficiaries of the recently passed tax reform legislation.

Now, investors are pondering what banks will do with their increasing cash stockpiles. Capital levels at major U.S. banks are viewed as solid. Additionally, the Trump Administration’s tax reform effort is seen as a potential catalyst for the financial services sector, but it remains to be seen if that effort will come to life. Some industry observers expect the tax reform would help banks boost earnings in significant fashion.

“Banks are notching 7%-plus annual growth in capital in excess of industry needs, and many have chosen to use those funds to reward shareholders via stock repurchases and dividends,” reports Barron's. “But some have worried that these share buybacks aren't terribly efficient, point to low returns on investment.  However, Keefe, Bruyette & Woods' Frederick Cannon argues that these concerns are overblown.”

Deregulation could also help the financial sector improve their margins. President Donald Trump has shown its eagerness in cutting back the red tape and remove some of the post-financial crisis regulations that has stifled the industry.

Meanwhile, the rising interest rate environment is also good for net interest margins for banks and more so for insurance companies. Given the latest strength in the U.S. employment data, many anticipate the Federal Reserve to hike rates at least three times this year.

“Cannon notes that a bank's book value per share increases as long as share repurchases don't exceed earnings. Moreover, even if a bank distributes 150% of its earnings (50% in dividends and 100% in share repurchases) while repurchasing shares at two times book value, book value per share is still maintained, assuming no growth in assets,” according to Barron's.

Some good news for XLF and friends is that the financial services sector is widely regarded as perhaps the only sector in the U.S. that is attractively valued relative to the broader market and its own long-term averages. The financial sector valuations still look relatively cheap, compared to the broader market. The sector’s valuations are still about 25% below the average since the early 1990s.

For more information on the financial sector, visit our financial category.

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