The U.S. mid-cap financials held up very well in 2022, in what was a very difficult year for the global financials. Risks that had not been seen for decades – like inflation – have returned, and the market’s fears that rising central bank rates could trigger a recession remain high. This has resulted in significant compression in price-to-earnings multiples as the market anticipates clouds ahead.
Yet, despite these clouds, in 2022, the Hamilton U.S. Mid/Small-Cap Financials ETF (HUM, HUM.U) was the top performing U.S. financials ETF in Canada – again. Two years ago – in 2021 – HUM was the top performing financials ETF in Canada – foreign or domestic. Since inception HUM is 10% ahead of the next best performing U.S. financials ETF in Canada with an annualized return of 21.6%. Over the same period, HUM.U (the same fund denominated in US$), outperformed the largest U.S. financials ETFs on a total return basis including XLF (~5.9%), VFH (~7.2%), KBE (~1.9%), and IAT (~6.4%). For more information, see our insight “HUM – Top Performing U.S. Financials ETF in Canada – Again” (January 6, 2022).
As the rate cycle matures and the economic cycle advances, investors will inevitably look forward to these storm clouds receding. This should create opportunities for stocks poised to show improvement from earnings growth and valuations. In our view, the U.S. mid-cap financials fall within this category.
As we discuss in detail below, in our opinion, HUM looks attractive for four key reasons: (i) attractive absolute and relative valuations, (ii) long-term outperformance of the category bodes well for the future, (iii) high-growth geographic footprint supports revenue growth and, over time (iv) a likely resurgence in M&A activity.
Reason #1: Mid-Cap Financials are Very Inexpensive (both Absolutely and Relatively)
The U.S. mid-cap financials are very inexpensive on both an absolute and relative basis, suggesting potential upside in the form of multiple expansion. Looking at the graph below, the S&P 400 Financials (S4FINL), which is the index of mid-cap financials within the S&P, is currently trading at 10.0x next year’s earnings. On an absolute basis, this is materially lower than its 20-year average of 14.4x.
The U.S. mid-cap financials are also inexpensive relative to the S&P 500 and are currently trading at a much lower P/E relative to the S&P 500 than they have for most of the past ten years (see chart). And the difference is highly material, with the relative P/E at ~58% versus an average of 90% and a peak of 150%.
Reason #2: Mid-Cap Financials have Significant Long-Term Outperformance versus their Large-Cap Peers
The U.S. mid-cap financials have a strong performance history relative to their large-cap peers over the last 20 years (see chart below). Consistent with this relative performance, since inception, the Hamilton U.S. Mid/Small-Cap Financials ETF (HUM) is up ~21.6% (annualized) and HUM.U has outperformed the large-cap financials (S5FINL) by ~1.7% (annualized).
What are the reasons for this long-term outperformance? In general, the U.S. mid and small cap financials have outperformed their large-cap peers for three major reasons. First, the category has benefited from secular consolidation, a powerful trend which began in the 1980s (more on this below). Over time, ongoing consolidation has continued to create efficiencies that have supported earnings growth and shareholder value (including merger premiums). Second, the category is generally less risky, as the mid-caps have simpler business models and strategies. Over time, their large-cap peers, which are often in “riskier” businesses/geographies have experienced value destruction from either their capital markets/trading operations and/or their foreign platforms.
Third, regulatory risk for the large-caps has increased significantly, while the regulators generally favour the mid-caps. For the large-caps, this has resulted in higher capital requirements, stricter oversight, and/or risk-management obligations, which has often been followed by large fines and/or regulatory sanctions. Going forward, the large-caps are likely more exposed than their mid-cap peers to the widespread uncertainty about the global outlook, war in Ukraine, an energy shortage in Europe and COVID (and geopolitical) uncertainty in China.
Reason #3: Exposure to Higher Growth States Should Support Higher Revenue Growth
Geography matters when it comes to investing in financial services companies, as population growth supports GDP growth, which in turn drives revenue growth. Within the United States, there are many distinct regions that have large differences in population and GDP growth. For this reason, HUM has disproportionate exposure to higher growth states.
The chart below, using data from the U.S. Census Bureau, highlights the robust trends for internal migration and movers from abroad to the West and particularly the South. Negative trends for net internal migration are evident for both Northeast and Midwest. This has implications for the economic growth of all these regions.
Given that the Hamilton U.S. Mid/Small-Cap Financials ETF (HUM) is actively managed, it allows us to focus on financials that are operating in higher GDP growth economies. Most notably HUM places greater weights on the fast-growing South and West (e.g., FL, TX, GA, NC, TN) at the expense of the slower growing Midwest and Northeast (e.g., IL, NY, NJ, CT, OH, PA). In our opinion, this exposure to faster growing regions provides sustainable tailwinds to its long-term growth trajectory.
Reason #4: Mergers & Acquisitions Remain a Key Theme for the Medium Term
As mentioned, the regulators favour the mid-caps including supporting continued consolidation/M&A. For example, in September, U.S. house hearings on banking oversight, two members of the committee highlighted that increased competitiveness and greater financial stability were benefits that might accrue from allowing more M&A of smaller and medium sized financials to compete with the larger peers. Additionally, the number of banks in the U.S. remains large and highlights the ongoing potential for efficiency gains through consolidation.
The potential for a more stable economic environment, could make M&A an additional tailwind for mid-cap financials that stand to benefit from the realization of synergies created by merging. In contrast, large-cap financials are often limited by competition regulation from growing by acquiring with several prohibited by statute from growing their deposits by acquisitions. That said, consolidation remains a constant. Late 2021/early 2022 saw some notable M&A within the mid-cap financial sector (market cap below US$20 bln):
- BMO announced the purchase of the Bank of the West (US$16.3 bln)
- TD Bank Group’s announced purchase of First Horizon (US$13.7 bln) – which HUM owned
- Berkshire Hathaway’s completed purchase of Allegheny Corp (US$11.6bln)
- AFCO Credit Corporation’s complete purchased of Bankdirect Capital Finance from Texas Capital Bancshares (US$3.4 bln)
Given the U.S. mid-cap financial sector still consists of hundreds of firms, we believe that once markets stabilize and stock prices improve, this powerful secular trend of consolidation will resume.
Mid-Cap Financials Look Attractive, Despite Clouds
We believe the Hamilton U.S. Mid/Small-Cap Financials ETF (HUM) is well positioned to an economic recovery or improvement in sentiment. It has outperformed in both up and down markets contributing to its material outperformance relative to its large-cap peers in both Canada and the U.S. In our view, HUM should benefit from its focused exposure to the U.S. economy and its inevitable recovery despite possessing lower risks relative to the large-cap financials. The fund continues to focus its allocations on higher growth locations within the U.S. and companies with experienced management teams that have demonstrated the ability to grow earnings robustly over the business cycle. In the meantime, the sector is very inexpensive, with long term tailwinds and meaningful potential for upside surprises.
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 Source: Hamilton ETFs, Bloomberg. The universe of U.S. financials ETFs in Canada includes the following: RUBY, RUBH, ZBK, ZUB, ZWK, CALL and HUBL.
 Source: Morningstar
 In Canadian dollars. HUM was launched on June 26, 2020. Performance since inception measured to December 30, 2022.
 In U.S. dollars. HUM.U was launched on June 26, 2020. Performance since inception measured to December 30, 2022.
 As of December 31, 2022.
 HUM was launched on June 26, 2020. Performance since inception measured to December 30, 2022.