When investing in banks, I'm thinking big

The early-2023 turmoil that beset U.S. regional banks has created opportunity for some of the industry's largest firms, according to Fidelity's Matt Fruhan.

• While U.S. lenders have languished following the high-profile failure of several regional banks in March, including Silicon Valley Bank, Fidelity's Matt Fruhan believes investors have painted the industry with an overly broad brush and sees opportunity among some of its biggest players.
• "I view the recent struggles as a development that may enhance the appeal of some of the nation's largest banks, including Wells Fargo and Bank of America," points out Fruhan, portfolio manager of Fidelity Advisor^® Growth & Income Fund.
• More importantly, he feels these companies will take market share from their smaller competitors, while at the same time, facing far lower risk of a bank run.
• Fruhan's preference for big banks partly stems from his belief that securities can become mispriced relative to their true long-term value when investors become increasingly focused on the short term. "My investment process seeks to exploit these discrepancies to drive the fund's performance," he says.
• In March, most financial stocks experienced severe valuation compression, as the market started to worry about banks losing deposits and the impact this would have on institutions' net interest income, capital, and earnings per share, according to Fruhan.
• For some historical context, he notes that when interest rates were low and the U.S. Federal Reserve was pumping liquidity into the market, money found its way into the banking system through low-cost deposits. In turn, banks took these low-yielding deposits and invested them in long-duration, relatively low-yielding securities.
• However, as interest rates have sharply risen, bank customers have seen a gap between the fairly high yields they can earn in money market funds and other investment vehicles, compared with the much lower yields offered by traditional checking and savings accounts, explains Fruhan.
• "Banks were caught in a scenario of having to either raise deposit rates above the level they had reinvested them to keep customers from moving to money market funds or allow the deposits to leave and sell the securities at losses," he states.
• This has led to nervous account holders moving around and even leaving banks altogether, according to Fruhan, who considers this deposit flight as a rational concern for small- and mid-cap banks.
• "As I see it, the super-regional and mega-cap financial institutions are considerably better positioned to withstand such scenarios," he contends.
• Accordingly, banks have represented the fund's largest industry overweight, with its holdings concentrated in large financial institutions such as Wells Fargo and Bank of America (as of October 31).
• In contrast, Fruhan has decided to avoid smaller-cap banks in the benchmark, based on his belief that scale matters in this industry.
• This is especially true when it comes to managing funding costs, maintaining geographic breadth, and spending on technology, all of which, Fruhan concludes, leads to higher returns on capital and a lower cost of capital.