Investment Thesis

As it concludes a disappointing 2020, The Financial Select Sector SPDR® Fund (XLF) is well set up to reap the rewards of a historically solid-performing Financial Services sector. Not only is its current security allocation advantageous over previous periods, but its constituents have proven they can deliver results during bull markets and recover strongly after economic downturns. In this article, I will show you why bulking up on U.S. Financial Services stocks using XLF makes sense for both value and growth investors, and why you may need to be a bit patient as banks navigate an incredibly complicated environment brought on by the COVID-19 pandemic.

ETF Profile

SSGA Funds Management, Inc. is the investment manager listed for XLF, which tracks the Financials Select Index provided by S&P Dow Jones Indices. Following the same modified market-cap-weighted methodology as the S&P 500, XLF has nearly $21B in AUM and an expense ratio of 0.13%. The ETF has been listed since December 22, 1998, and distributes an annual dividend of $0.54, which works out to a trailing yield of around 2%. Additional fund and index characteristics are shown below.

XLF Fund and Index Characteristics

Source: State Street Global Advisors

XLF is fairly concentrated as one would expect for a sector ETF, with its top 15 holdings comprising roughly 2/3 of the fund.

XLF Top 15 Holdings

Source: ETF Database

What is not mentioned in XLF’s Fund Profile is that 59 of its 65 holdings have a trading history of at least 12 years. This is important, as it means that the vast majority of its holdings have survived and thrived since the Global Financial Crisis.

Historical & Current Composition By Sector

The first thing I would like to highlight is that when analyzing an ETF, it is generally insufficient to rely only on an ETFs historical performance with a tool such as Portfolio Visualizer. It is not the same as using it for individual securities because ETF holdings, and their weightings, change over time and sometimes substantially. Remember that you are buying an ETF for what it is today, not for what it was five or ten years ago. Your assessments of past risk and return to predict future results become less reliable if the ETF allocations have materially changed.

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Therefore, I will begin my analysis with a historical industry breakdown of the fund dating back five years. I retrieved this information from the Annual Reports submitted by SSGA, the most recent of which can be found here.XLY Industry Allocations By Year

Source: Analysis By Author

As shown, banks have heavily sold off which has resulted in higher allocations to the Capital Markets and Diversified Financial Services industries. With a steady allocation above 40% from 2016-2019, banks now have a much smaller presence due to the poor recent returns of index heavyweights such as JPMorgan Chase (JPM) and Bank of America (BAC). This sets up an opportunity for value investors who are optimistic about a post-pandemic recovery in the banking sector.

There’s something for growth investors to get excited about as well. Since the 15% allocation to Diversified Financial Services is comprised entirely of Berkshire Hathaway (BRK.B) stock, Buffett’s 40% allocation to Apple (AAPL) adds a little bit more diversification than a typical sector ETF would provide. For Berkshire’s latest holdings as reported in its November 16, 2020, 13F filing, please visit here.

Margin Analysis: Pre And Post Pandemic

These last few quarters have been difficult for the Financial Services sector, but it is important to highlight just how resilient it has been over the last decade or so. For this part of the analysis, I am going to use operating margin as the main measure of a company’s success. Share prices are too volatile and are subject to an efficient market, while net margins can include extraordinary events which are not likely to repeat.

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Below is an operating margin summary for XLF’s top five banking industry stocks from 2005-2020. I have bolded selected significant declines to give you an idea of how long it took each company to recover.

Banking Operating Margin Table

Source: Analysis By Author Using Data From MacroTrends

For many companies, the recovery took just one or two years. JPMorgan Chase (JPM), for example, saw its operating margin slashed by over 16% in 2008 but recovered strongly the following year and was back up to 2007 levels by 2010. The warning signs for Bank of America (BAC) came a year earlier and the recovery took longer than other leading U.S. banks, but it eventually got back to 20%+ margins in 2015. Finally, Citigroup (C) struggled from 2007-2008 but returned to its usual margins by 2013. While it remains a shadow of its former self, a weighting of just 3.46% is not going to drive XLF’s performance as it did back in 2007 and 2008. For example, on September 30, 2008, Citigroup’s index weighting was more than double at 6.90%.

I present the data this way to remind you how resilient U.S. banks are. In 2020 we have seen similar reductions in operating margins, and for those looking to follow Warren Buffett’s advice of buying when others are fearful, now may be as good of a time as any. History supports a strong recovery, even if it may take some time.

COVID-19 Impact

We should all acknowledge the uncertainty brought on by COVID-19 and how quickly the U.S. economy can get back on its feet. President Trump and President-elect Biden are showing little signs of coordinating the distribution of two vaccines developed by Pfizer (PFE) and Moderna (MRNA). As further restrictions are introduced, businesses will suffer and many will take out loans to keep afloat. Insolvencies are likely to increase, and stimulus talks are going to have to wait as the Senate has adjourned through Labor Day. There are so many moving parts that it is nearly impossible to predict what an eventual recovery will look like.

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S&P Global Ratings has acknowledged this as discussed in its most recent Global Banks 2021 Outlook report. However, they also describe just how resilient the top banks are in a comparison of credit ratings between November 2019 and today.S&P Global Bank Credit Ratings Changes

Source: S&P Global Ratings

As you can see, ratings haven’t materially changed for the top 200 rated banks despite the pandemic. This speaks to the size, leverage, and capital market access advantages the biggest banks enjoy over their smaller competitors. Consolidation within the industry is likely to occur over the next few years, which is why it makes sense to invest in a market-cap-weighted ETF such as XLF. As the Financial Services sector recovers, look for banking stocks to lead the charge.

Investment Recommendation & Conclusion

The Financial Services sector has proven itself to be a resilient one, even if the timing is difficult to predict. Investors should focus on the long-term by increasing their allocation to the sector’s largest companies, and they can do this in a cost-efficient manner by investing in XLF. As operating margins improve and consolidation occurs, XLF’s largest constituents will benefit the most and drive significant returns for investors. I’m bullish on this ETF and would recommend buying it today for significant returns in the future.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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