It finally happened. The Federal Reserve just lowered interest rates by 50 basis points (0.5% in percentage terms). Investors rejoiced, sending the S&P 500 to new, all-time highs. The stock market is now up 100% during the past five years, driven by rising earnings ratios and the artificial intelligence (AI) boom despite the Fed taking interest rates from zero to 5% two years ago.
Not every company is at all-time highs, though. Enter Ally Financial (ALLY -1.00%). The consumer bank and automotive lender has faced headwinds on deposit costs due to rising interest rates, which are now starting to reverse. Here's why Ally, which is among several bank stocks Warren Buffett's Berkshire Hathaway owns, is a perfect buy with the Fed now lowering interest rates.
Battling interest-rate headwinds
Ally's goal is to disrupt consumer banking with an online-only bank that offers depositors consistently high interest rates. They have lived up to this promise and executed brilliantly during the past decade: It currently has $142 billion in retail deposits. It consistently pays higher interest on savings accounts compared to the big banks, which is why it can win customers from the likes of Bank of America. Currently, Ally is giving depositors a 4.2% annual yield for parking money with it.
Deposits are the fuel a consumer bank uses to make loans, which is how they generate profits. Ally makes the majority of its loans in the consumer-automotive market, driven by its relationship with automotive dealers across the U.S. These loans are typically a few years in length and are based on the prevailing Fed interest rate and U.S. Treasury bond yields at the time of loan origination.
This presented a problem for Ally when the Fed rapidly hiked interest rates to fight inflation. Why? Because to maintain its appeal to depositors, the bank was forced to raise the interest paid out on deposit accounts. The blended interest cost on deposits for Ally was 4.21% last quarter compared to a measly 0.77% in the second quarter of 2021. This was a huge cost at the same time that the average yield on its loan book rose slower. If automotive loans are around three years in length, loans made in 2021 and 2022 are still on Ally's balance sheet, which were made when interest rates were zero.
Rising interest rates have compressed the spread Ally earns from its deposit costs vs. the yield on loans it makes, which is known as the net-interest margin (NIM). As the Fed lowers interest rates, this headwind will slowly subside and help Ally's earnings grow.
Lower interest rates help both sides of the business
When the Fed lowers interest rates, it helps Ally on its consumer-banking business. Across the banking industry, interest rates paid to depositors will fall, lowering one side of the NIM equation.
On the loan side, it will help Ally as well. First off, yields on the existing loan book won't fall as quickly as market interest rates, helping the other side of the NIM. Second, lower interest rates mean Ally can offer car buyers lower interest rates on automotive loans. This will help consumers more easily afford cars and make it more likely they will repay loans fully. Ally has mentioned increases in auto delinquencies in recent quarters, which can hurt profits. Lower interest rates will hopefully reduce the risk this trend worsens.
ALLY Dividend Per Share (TTM) data by YCharts.
Buy this stock for dividend growth
It is clear that lower interest rates will help Ally Financial's profitability. And yet, this recovery does not seem to be priced into the stock, which is why I think now is a perfect time to buy the dividend-growth stock and hold for the long term.
Today, Ally has a market cap of $10.5 billion. During the past 12 months, it has generated $823 million. Just a few years ago, the bank was generating close to $2 billion in net income. Once its NIM recovers, its earnings will start moving back toward these prior levels.
This earnings growth should fuel growth in Ally's dividends, which has grown by 275% since the bank began making payouts in 2018. At a current yield of 3.5%, investors are getting a high-yield entry point today too. This makes the Warren Buffett bank an easy buy for dividend growth right now.
