In scenario one, with no earnings growth and no price/earnings (P/E) expansion, Davis said he still projects a 7% average annual shareholder return achieved through repurchases and dividends.

In scenario two, with modest earnings growth and no P/E expansion, Davis said he projects a 10% average annual total shareholder return driven by a modest earnings growth of 3% per year, and share repurchases and dividends.

In scenario three, with modest earnings growth and modest P/E expansion, Davis projects a 13% average annual total shareholder return generated by a modest earnings growth of 3% per year, a modest P/E expansion from 12x to 14x, in addition to share repurchase and dividends.

“Going forward, we expect an outcome between Scenario 2 and Scenario 3 to be the most likely,” Davis said. “This would represent a very satisfactory return for shareholders.”

Davis indicated that key to realizing a return on investment in financial stocks was active management of investors’ portfolios.

Davis said that despite this optimistic outlook for financial stocks, many investors remained wary of them. He asserted that since all major U.S. banks now undergo annual stress tests that measure the degree to which they are willing or able to leverage financial products, and the overall risk to them when they do, the balance sheets for major financial institutions today look very strong. Furthermore, Davis said, with a stronger economy and relatively full employment, demand for loans has risen and credit costs are normalizing, which is expected. 

“We believe the credit environment remains both very manageable and quite favorable,” he said. 

Davis said that the biggest hurdles to investing in financials in the current environment are psychological and emotional because investors still remember the aftermath of the 2008 financial crisis—even though select financial companies are delivering record earnings and have the strongest balance sheets in decades.

“When stock prices go down, people feel more fear and are less interested in buying, and when prices go up, they feel reassured,” he said. “This tends to result in an undesirable outcome.”

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