'Growth stocks in disguise': Lower rates are supposed to crush bank shares - but one multi-billion-dollar manager says they could explode 10% higher

Reuters / Lucas Jackson

• Christopher Davis - chairman of Davis Advisors and portfolio manager of Davis Funds, which oversees more than $9 billion - thinks financial stocks are getting a bad rap in the wake of the Federal Reserve's decision to cut rates.
• While they're an unpopular pick right now because of what lower rates will do to their interest income, Davis says they possess immense upside.
• He details his rationale, and attributes the group's recent lag in performance to investor psychology and reverberations from the financial crisis.
• Click here for more BI Prime stories.

In the late stages of a bull market, a phrase you'll often hear is: "the easy money has already been made."

However, just because the market is almost 350% higher than it was at the start of the bull run doesn't mean all opportunities have evaporated. And one prominent portfolio manager thinks a great one exists in an area that's recently been shunned by investors.

Christopher Davis - chairman of Davis Advisors and portfolio manager of Davis Funds, which oversees more than $9 billion - sees financials as an unloved sector that's poised to outperform. And he's calling for double-digit returns.

"Where they're positioned, where they're valued, what they're doing with the capital they generate - looks to us on track to earn, in a fairly low-risk set of assumptions - a return that exceeds 8%, maybe more in the 9%, 10%, 11% range," he relayed on Money Life with Chuck Jaffe, an investing podcast.

Davis' call comes at an interesting time. Financials have slightly lagged benchmarks in 2019 thus far, and fell by more than double the S&P 500 in 2018.

What's more, the space is expected to come under additional pressure now that the Federal Reserve has cut interest rates for the first time in more than a decade. Sector pessimists argue that a decline is inevitable, given the negative impact lower rates will have on interest income, which is crucially important for the bottom line of the biggest firms.

Read more: Billionaire 'Bond King' Jeffrey Gundlach unpacks a market phenomenon that takes place just before a recession hits - and warns it's happening right now

Davis also blames the aftershocks of the financial crisis for souring some investors on the space.

"We have gone through a once in a generation financial crisis," he said. "You get a whole generation that is scarred."

But he disagrees with this mentality.

"The reality is that they're far safer, they're far better capitalized, they're well-regulated, they're dispositionally conservative," he said. "And yet, because of the perception, they're also undervalued."

To Davis, the market's issue with the financial sector is more of a psychology problem than a fundamental problem. And this sets the stage for what he believes could be a huge, lengthy run.

"At today's valuations, you're starting with a 8-9% distributable free cash flow yield," he said. "Modest growth at the top line, sort of 3% can generate a 9%, 10%, 11% return to shareholders."

For this reason, Davis refers to financials as "growth stocks in disguise." He argues that while the space may seem like a slow-growth sector on the exterior, it's really a hidden cash-cow - one the market is still undervaluing.

For context, investors interested in getting involved can add exposure to financials through high-profile individual names such as Bank of America (BAC), Wells Fargo (WFC), and JPMorgan Chase (JPM). They can also purchase exposure to the entire sector through an ETF, such as the SPDR Financial Select Sector fund (XLF).