Bank Rally Likely to Shift to Micro-Caps

After lagging the market for years, US financial stocks surged after Donald Trump’s surprising win in the US presidential election. Investors can still profit from investing in banks; in our view, many of the best opportunities now lie in the micro-cap banks the rally left behind.

Banks led the market up in the fourth-quarter rally, on widespread hopes that faster economic growth, rising interest rates, lower taxes and bank deregulation would boost their earnings. On average, banks with at least $1 billion in assets returned 26% in the quarter. But micro-cap banks—those with less than $1 billion in assets—on average, returned just 10%, as the left side of the Display below shows.

That return gap does not reflect fundamentals, our research suggests. Micro-cap banks are likely to benefit just as much from faster economic growth, corporate tax cuts, deregulation and rising interest rates as larger banks.

Rather, micro banks were left in the dust for a technical reason: Very few of them are included in bank exchange-traded funds (ETFs), which generally buy larger, more liquid bank stocks. When the bank rally began, many investment managers that were underweight banks rushed to add exposure by buying bank ETFs, and banks included in the ETFs soared far ahead of those not included.

We could see the impact of ETF membership within our own holdings of micro-cap banks. Those included in bank ETFs rose 32% in the fourth quarter of 2016, while those not in bank ETFs rose 19%, as the right side of the Display above shows.