What’s Next for Financials After 2024 Outperformance?

Key Takeaways

» Financials outperformed the overall market in 2024 due to the steeper yield curve, falling rates, and the strong U.S. economy.
» Under a new presidential administration, there could be a loosening of regulations, which could improve bank profits.
» Bank M&A picked up in 2024 with more transactions and a higher total deal value.
» Valuations in the Financials sector remain inexpensive relative to the overall market.
» The Hennessy Large Cap Financial Fund diversified its bank exposure into transaction processors, investment banking, and a crypto exchange. » The Hennessy Small Cap Financial Fund continues to hold a concentrated number of primarily regional banks that engage in traditional banking across the U.S.

The Russell 1000® Index Financials rose nearly 32% in 2024, outperforming the S&P 500 Index by nearly 700 basis points. What drove the outperformance?

A few changes to the macroenvironment drove the Financials sector to top the overall market in performance in 2024 including the following:

1. The inverted yield curve reversed and rates fell. The yield curve shifted back to a normal upward slope where short-term rates are lower than longterm rates. The steepening yield curve along with lower short-term interest rates helped to improve bank margins.

2. A U.S. recession has been avoided. Previous recessions have been preceded by an inversion of the yield curve. A recession could result in a rise in credit quality issues, hurting bank performance. Over 2024, a recession did not materialize but rather the U.S. economy remained strong, which helped banks.

How might potential policy changes under a new presidential administration affect banks?

Under the new administration, we believe there will likely be a loosening of standards. Following many years of stringent bank stress tests implemented after the financial crisis of 2008, we may see a relaxing of the capital adequacy rules. While the annual stress tests were designed to ensure that banks were well positioned to weather a severe recession by staying above minimum capital requirements, they likely have also hampered both organic growth as well as merger and acquisition (M&A) activity. Since fewer regulations can improve banks’ profitability and growth, there could be more investor interest and higher bank stock prices, which banks could use to engage in M&A.

Regardless of the new administration’s actions, we believe the banking system is in excellent shape mostly due to the regulations put in place after the Financial Crisis in 2008 as well as in the 2020 pandemic era. On average, banks’ capital levels, asset quality, liquidity, and earnings have shown solid numbers. In addition, the most recent report from the Federal Reserve shows that 99% of U.S. banks are well capitalized. Bank failures have remained low, with only two small FDIC-insured banks closing in 2024.

Would you please discuss bank M&A activity?

From 2023 to 2024, there was an increase in M&A activity. In terms of total transactions, there were 101 and 128 transactions in 2023 and 2024, respectively. Total deal value also increased from the prior year, from $4 billion in 2023 to $17 billion in 2024.

With that said, there will likely not be a robust level of M&A activity that we have historically seen as there are significantly fewer banks. In 2000, there were 8,300 FDIC-insured commercial banks; currently, about 4,500 are in operation.

How do bank valuations compare to the broader market and on a historical basis?

With both the sector and the overall market increasing by double-digit returns in 2024, both experienced price-to earnings expansion. As of the end of 2024, the KBW Bank Index traded at 12x 2025 estimated earnings, a 5% discount to its 10- year average of 12.5x. Bank valuations are about 50% lower than the P/E of the S&P 500 at 22x 2025 estimated earnings.

What is the composition of the Large Cap Financial and Small Cap Financial Funds as we enter 2025?

As of the end of 2024, the Hennessy Large Cap Financial Fund has remained fairly concentrated with 25 positions. Over the year, we have diversified our bank exposure into transaction processors, investment banking, and a crypto exchange to potentially capitalize on its growth and new products. For comparison purposes, at the beginning of 2024, 62% of the portfolio was invested in traditional, regional and large diversified banks; by the end of the year, we reduced this exposure to 48%.

For the Hennessy Small Cap Financial Fund, the portfolio holds a concentrated number of primarily regional banks that engage in traditional banking across the U.S. The number of companies has increased although two banks that the Fund held were acquired during 2024. Overall, we increased the number of holdings from 29 to 36 stocks.

Overall, we believe both portfolios are well positioned for the current economic and interest rate environments.