When it comes to banks, patience is a virtue

Undervalued banks with a superior deposit base may be best positioned to pay off following the recent sharp increase in interest rates, according to Fidelity's Matt Reed.

• The Federal Reserve's aggressive campaign to raise its benchmark interest rate the past couple of years has been a headwind for banks, leading to opportunities in undervalued institutions with superior deposit franchises, says Fidelity Portfolio Manager Matt Reed.
• "Banks are long-cycle businesses, meaning that it takes a while for their balance sheets to adjust to rapid changes in interest rates," says Reed, who manages Fidelity Advisor^® Financials Fund. "So, if rates stay about where they are, or decline gradually as forecasted, but with less volatility, banks should be in good shape, assuming no major credit events from a slowing U.S. economy."
• Reed explains that with a historically rapid rate-hiking cycle, many lenders just haven't had the time yet to adjust, so taking a multiyear view and not getting sidetracked by near-term noise will be crucial to investing success.
• In running the sector-focused fund, Reed targets high-quality companies he believes can drive robust growth and risk-adjusted shareholder returns, as well as improving businesses that he feels are underappreciated by the market.
• Overall, he notes that interest rates sustainably higher than near-zero levels are a good thing for banks because it allows them to earn a larger net interest margin, which is a key measure of profitability.
• However, Reed reiterates that when rates reset higher as quickly as they did during the Fed's monetary tightening campaign that began in March 2022, it can cause short-term dislocations for lenders.
• Still, even in the current situation, he acknowledges that given enough time, the asset and liability sides of banks' ledgers should be able to adjust to a higher rate environment.
• Within the portfolio, Reed favors banks with superior deposit franchises, as well as underappreciated opportunities to grow the business, as demonstrated by notable holdings in Wells Fargo, PNC Financial Services Group and M&T Bank as of March 31.
• At the same time, Reed remains vigilant about limiting exposure to lenders with certain vulnerabilities, including rapid growth that might trigger increased regulatory scrutiny, or excessive exposure to potentially problematic segments of the market, such as commercial real estate.
• "Working with Fidelity's extensive research team, I feel good about our ability to identify the banks with the potential to persevere through the current environment and be well-positioned for the long term," says Reed.