There’s no sugar coating it: The past few weeks have been rough sledding for most stocks. The war in Ukraine is raging, of course, and inflation is running hotter than at any point in the last 40 years. There’s some truth to the popular explanation that it’s supply chain-related, but the truth is we’re seeing wage inflation, as well, and that’s not going to resolve itself quickly.
Sanctions against Russia are just starting to bite there, but we haven’t seen the effects ripple through the world economy yet outside of the energy sector.
The S&P 500 and Russell 2000 are both down nearly 10% for the year; the tech-heavy NASDAQ 100 is down nearly 15%.
The pros aren’t faring much better. Cathie Woods, Wall Street’s favorite stock-picker in 2020 and most of 2021, is down nearly 28% for the year, going by her ARK Innovation ETF (NYSEArca: ARKK).
It might feel like there’s no place to hide, but I’m here to tell you, the perfect getaway is here in the stock market if you know where to look for it.
I’m not talking about options or some exotic derivatives, either; I’m talking regular stocks you can buy and sell all day with the push of a button.
I’ll name the sector, and the stock to buy, right here…
These Stocks Eat Inflation for Breakfast
Investors panic about inflation because higher inflation means higher interest rates. That’s bad news for most companies because the cost of money – borrowing it and repaying it – goes up.
Higher rates also lead to lower valuations using most of the valuation models used by Wall Street analysts and investment bankers. Lower valuation means lower stock prices, especially for companies with strong revenue growth but no profits.
So that’s two dings against the kinds of flashy stocks people just couldn’t get enough of during the pandemic.
Now, this would be a good time to mention one of the earliest lessons of my career. It comes from the late Great Marty Zweig, who insisted that the best way to lose money was to fight the Fed.
If the Fed is cutting rates, stocks are probably going to go higher.
If the Fed is raising interest rates, stocks are most likely going to head lower.
There have been exceptions, of course, but “Don’t Fight the Fed,” or “Ye King’s Own Banker,” or some variation on that theme, has been a useful rule of thumb for the past 350-odd years central banks have existed.
There is one exception to this rule – especially today, when rates have been so low for so long.
Take a look at the FirstTrust NASDAQ ABA Community Bank Index Fund (NASDAQ: QABA). It’s holding its own this year, unlike a lot else.
There’s a good reason for that. Community banks love higher interest rates. Why? Because higher interest rates mean higher net interest margins, and that means higher profits for banks, and that means higher prices for those banks’ stocks.
The QABA index itself is down about 0.4% for 2022, but it’s already bouncing back strongly. That might not seem like much, but I bet you the investors who have ridden the Ark funds down to huge, double-digit losses would trade places with the owners of the bank ETF in a heartbeat.
But QABA isn’t my recommendation today – I’m only looking at sector performance. I’m going to name my top pick here in a second.
My Favorite Small Bank Stock Strategy – and My Favorite Bank Stock
When it comes to bank stocks, you want high dividend-paying bank stocks that trade with a low price-to-earnings (P/E) ratio. That strategy is doing much better than the indexes, with a return of about 2.5% so far this year.
The basic approach also crushed the S&P 500 in 2021 despite the broader market’s outstanding performance during the year.
In fact, my data shows that just owning high-yielding community banks stocks that have a low P/E ratio has crushed the S&P 500 over the past five-, 10- and 20-year time periods.
I always laugh out loud when someone says that owning banks stocks is boring. If booking higher returns than the S&P 500 at a fraction of the volatility is “boring,” I don’t want to know what you think is “exciting.”
It’s tempting to want to keep a good thing to yourself, but I’ll spill the beans on my top pick here.
Heritage Financial Corp. (NASDAQ: HFWA) is an excellent example of a well-run, high-yielding bank that we can buy at a low P/E ratio right now – 9.6, to be exact. That’s around 2.5 times lower than the S&P 500 P/E.
Heritage is based in Olympia, Washington, and has been a fantastic growth story over the past decade. The bank has grown from about $1.3 billion in assets to over $7.4 billion in assets.
A lot of the growth has come from well-executed acquisitions. Heritage has bought seven other banks in the region to help grow and expand its service area. Its goal is to be considered the “acquirer of choice” in the Pacific Northwest, and it looks to me like it’s doing a great job of it. Heritage tends to target banks where the valuation and cost savings allows Heritage Financial to earn internal rates of return of more than 15%.
Heritage currently has 55 branch locations in the Interstate 5 corridor between Portland and the greater Seattle area.
About 55% of the bank’s loan book is in commercial real estate, and another 14% is in loans to area businesses. The bank has closed or consolidated 35 branches since 2010, including 12 in 2021 alone. Increasingly they are turning to digital offerings as the demand for in-branch banking services has declined since the beginning of the pandemic.
When I consider parting with my hard-earned money to own a stock, I look at the whole top-to-bottom operation – and you should, too. What I’ve found is the lending team at Heritage is really good at what they do. The nonperforming assets rate is just 0.30%, about two-thirds of the national average. In addition, nonaccrual loans have decreased 59.1% since Dec. 31, 2020, to 0.32% of total assets as the economy has begun to normalize.
This Company Loves Putting Cash in Your Pocket
Heritage Financial has been very generous about rewarding shareholders. The stock is yielding 3.25%, and the payout has been increased by about 14.5% annually for the past several years. It even raised the dividend in 2020, when many banks decreased or deferred dividends to shareholders.
Heritage has also been good about buying back stock – another activity I love to see. Repurchases in 2021 totaled $22.1 million, or 904,972 shares of common stock, and represented approximately 2.5% of the total shares at the start of the year.
Heritage is working to be a leader in using new technology to serve its customers. It has developed a program it calls HeritageONE to create new technology and digital offerings and roll them out efficiently to its customers. Heritage has also invested in the JAM FINTOP Blockchain fund to gain early access to innovative blackchin solutions for the banking industry. Heritage is actively exploring ways to use blockchain as a part of HeritageONE.
Heritage Financial is a growth story as it is constantly looking for banks to buy at the right price to add to its asset base, but it’s also a tech story – and not just because the bank is a technology leader in the banking sector. The largest employers in its home market include Microsoft Corp. (NASDAQ: MSFT), Amazon.com Inc. (NASDAQ: AMZN), Intel Corp. (NASDAQ: INTC), and a host of other large technology and cutting-edge consumer companies.
It’s a pretty safe bet that Heritage Financial is doing business with many small and mid-sized tech companies, executives, and employees who supply these tech giants.
It is a dividend and dividend growth story as well. The stock has an above-average yield, and management has been generous about raising the payout regularly.
It is also a value story as we can buy the stock for less than 10 times earnings right now.
And last but not least, it’s an inflation story; higher rates will mean higher margins and profits for the bank. In addition, the fact that 23% of its assets are in cash that can be invested at higher rates will also help boost profits in 2022.
Buying the right banks at the right price is one of the most consistently profitable ways I have ever found to make money in the stock market. Not using this wildly successful strategy is like leaving money on the table.
— Tim Melvin
Source: Money Morning