Selling your bank shares? Here's three small-cap alternatives to consider

While shares of Australia's major banks have delivered strong gains this year, high valuations, structural pressures, and the looming threat of RBA rate cuts – with the potential to squeeze margins – are clouding the outlook for future returns. For those selling bank shares to lock in profits, but keen to retain exposure to Financials that still offer significant growth potential, here are three small-cap alternatives to consider:

Australian Finance Group (ASX: AFG) is a mortgage aggregator platform and securitised lender that has been gaining traction for over a decade as mortgage brokers take share from banks. In the past six years, Australian banks have shuttered over 2,000 branches, with 800 of those closures occurring in regional areas. This trend has created an opportunity for AFG to capture a greater share of the mortgage market, as more customers seek alternative providers for their financing needs. AFG brokers now write more than 1 in 10 mortgages in Australia, and with the days of ultra-low fixed-rate loans and cashbacks offered by the major banks behind us (made possible by the RBA’s Term Funding Facility, which was only available to banks and repaid by June 30 this year), non-bank lenders such as AFG are now able to compete on a more level playing field again. One of AFG’s key advantages is its high-quality securitised lending book, having only experienced $260k of bad debts over the past 15 years. This solid track record gives investors confidence in AFG’s ability to manage risk effectively while continuing to grow. The company trades on only 11x P/E and pays a 6% fully franked dividend yield.

Judo Bank (ASX: JDO) is a business lender that is rapidly taking market share from traditional banks. Judo’s distinct approach to lending has enabled it to carve out a niche in the Australian market, offering tailored lending solutions to small and medium-sized enterprises (SMEs). Unlike traditional banks, which often have rigid lending criteria and lengthy approval processes, Judo provides more flexible, customer-centric solutions that are better suited to the needs of growing businesses. This unique proposition has allowed Judo to build strong relationships with its clients, providing financing for businesses that may have struggled to secure loans through conventional channels. Judo’s focus on the SME sector has proven to be a winning strategy. In a landscape where banks have been tightening their lending standards and ceding share, Judo has been able to differentiate itself by offering more personalised and efficient services resulting in 3x industry growth in FY24. With RBA rate cuts looming as inflation eases and employment remaining strong, Judo is well-positioned to continue capturing a larger share of the lending market as businesses look for financing options to fuel their growth. Judo trades on 18x P/E with earnings forecast to double over the next two years, in comparison to the major banks trading on an average of 17x P/E with earnings forecast to remain largely flat.

Zip Co (ASX: ZIP) is a consumer finance company that operates in the buy-now-pay-later (BNPL) space, offering users the ability to split payments into manageable instalments, providing a more convenient and budget-friendly way to make purchases. Zip’s major growth opportunity lies in the U.S. market, where BNPL penetration is still only around 2%, in comparison to more mature markets such as Australia and Europe where BNPL penetration is 15% and 20% respectively. The U.S. presents a huge growth opportunity for Zip as American consumers increasingly turn to BNPL solutions for their shopping needs and more merchants embrace the BNPL model. With increasing consumer demand for flexible payment options and Zip’s growing partnership network, the company is poised to benefit from the continued rise of BNPL adoption. A strong focus on customer experience and strategic partnerships with major retailers and distributors – for example, Amazon and Google Pay, and media reports that they will soon integrate with Apple Pay – Zip has the potential to keep growing for many years yet. Zip trades on consensus three-year forward P/E of 26x.

Conclusion

In summary, while bank shares appear overvalued and face structural challenges, companies like AFG, Judo, and Zip provide compelling alternatives for investors looking for growth opportunities in the Financials sector. AFG’s growing market share, supported by the closure of bank branches and its prudent lending framework, positions it well for long-term success in the mortgage space. Judo’s flexible, customer-centric model and focus on business loans offer a niche solution for SMEs, giving it a competitive edge over traditional banks. Meanwhile, Zip’s expansion into the U.S. market and its position as a leader in the BNPL sector gives it enormous potential for growth in consumer finance. Together, these three small-cap stocks offer exciting opportunities for investors seeking diversified exposure to new avenues of growth away from Australia’s big four banks.