Banking On Big Financials

12/3/2012


Few things look more opaque than the operations of a big bank. But a rising stock chart is easy to read.

Large banks in the S&P 500 Index (listed in the table below) have averaged total returns of 27.4% so far this year, ahead of the average of 19.4% for all S&P 500 financial stocks and 13.7% for all stocks in the index.

Those rising prices leave investors with an important question: Is there room for more gains?

Our answer: Yes, at least for some companies.

Big banks, as shown below, earn Quadrix Momentum, Value, and Overall scores well above their historical averages. The group's operating momentum, potential for dividend growth, and attractive valuation suggest the shares could climb higher.


BIG BANKS BOUNCE BACK IN QUADRIX

Below are statistics that show two important details. First, based on price/earnings and price/book ratios, big banks are cheap versus historical norms. Second, at 21% the dividend payout ratio is low by historical standards, indicating the potential for dividend increases.

-------------------- Historical Averages --------------------
Recent
Average
6 Mos.
Ago
1 Year
Ago
Last 5
Years
Last 10
Years
Since
1994
Quadrix Overall
74
70
68
48
59
62
Quadrix Momentum
66
64
61
47
46
49
Quadrix Value
81
77
84
62
71
64
P/E Ratio
10.6
11.1
11.0
15.7
14.9
16.1
Price/Book Ratio
0.9
0.9
0.8
1.0
1.6
2.2
Dividend Yield (%)
2
2.1
2
2.5
2.9
2.7
Dividend Payout Ratio (%)
21
23
21
35
40
38

Improving economic conditions spurred loan growth through much of 2012. Homeowners, motivated by low interest rates to refinance their mortgages, drove banking fees higher. If the housing market builds on recent momentum, banks' loan balances should keep rising next year.

Meanwhile, dealmaking remains a largely untapped source of revenue. Merger-and-acquisition activity has been fairly slow for the past couple of years, but U.S. corporations sit on record piles of cash and face pressure from investors to put that cash to work. More mergers mean more fees for investment banks.

Big banks have already provided plenty of hints about how they intend to use their own cash. They remain committed to rebuilding their dividends, with the big banks in the S&P 500 raising their per-share payouts an average of 26% over the last year. Yet the average large bank pays out just 21% of its earnings in dividends, well below historical norms. The scenarios in the Federal Reserve's 2013 stress test appear less strenuous than prior years with respect to required capital levels, which could allow banks to become even more aggressive with dividends and share repurchases.

Shares of large banks look cheap, earning an average Value score of 81. At less than 11 times trailing earnings, the average stock in the group trades 33% below its five-year average P/E ratio. The banks also look attractive based on price/book ratio.

These cheap valuations reflect a number of concerns, including:

• Loan demand may soften in the last few months of 2012 as U.S. businesses and consumers wait for a solution to the fiscal cliff.

• With interest rates low — and unlikely to rise for at least another couple of years — banks must reinvest their streams of loan payments in a shrinking pool of assets with attractive yields. The lack of high-yield options drags on net interest margins, shrinking the spread between interest collected on loans and interest paid to depositors. Bank profits could get squeezed if loan growth falters for an extended period.

• Since the election, big banks have averaged a loss of 4.3%, worse than the loss of 2.9% for the broader financial sector and 1.7% for the average S&P 500 stock. Blame that loss on at least two factors. First, Mitt Romney had vowed to repeal the Dodd-Frank financial reforms, but regulatory relief in the next four years now seems unlikely. Second, dividends for high-income Americans could be taxed next year at ordinary-income rates, potentially as high as 43.5% versus the current 15%.

Given the current environment, we believe the following three Buy-rated bank stocks have the best prospects for building on 2012 gains in the next year.

Fifth Third Bancorp ($15; FITB), a regional bank with more than 1,300 branches, mostly in the Midwest and Southeast, posted solid growth in mortgage banking and commercial loans in the September quarter. While the loan balance is still rising, growth has slowed; and the Federal Reserve's efforts to keep interest rates low could pressure profit margins at Fifth Third and other regional banks. But Fifth Third shares already discount plenty of concerns. The stock looks cheap at 10 times trailing earnings, a 27% discount to the median for regional banks in the S&P 1500.

Moreover, Fifth Third enjoys favorable credit trends, declining delinquency rates, and a rising deposit base. The bank expects to return roughly 70% of 2012 earnings to shareholders through dividends and stock buybacks, and the bank hopes to deliver similar largesse in future years. Fifth Third has boosted profits in recent quarters by drawing down its loss reserves, a trend likely to continue in coming quarters, if at a somewhat slower pace. For the December quarter, rising analyst estimates project per-share profits of $0.41, implying 21% growth. Yielding 2.8%, Fifth Third is a Buy and a Long-Term Buy.


With more than a touch of pride, CEO Richard Davis describes U.S. Bancorp ($32; USB) as a "pretty boring bank." For investors, there's beauty in the bank's boring, if consistent, growth. Revenue, operating profit margins, and return on assets have all risen year-over-year for at least 12 straight quarters. U.S. Bancorp earns above-average Quadrix ranks for all six Quadrix categories and an Overall score of 90. It scores especially well for Momentum (90), Earnings Estimates (88), and Financial Strength (99).

The bank's loan portfolio rose 7% in the first nine months of 2012 on 20% growth from residential mortgages and 19% from commercial lending. Management said uncertainty about the fiscal cliff could cause loan growth to slow in the final three months of 2012. Still, analyst estimates have climbed in the past 30 days. The consensus now calls for 17% higher per-share profits in the December quarter, followed by 7% growth in 2013. Trading at 12 times trailing earnings, 27% below its five-year average, U.S. Bancorp is a Buy and a Long-Term Buy.


Wells Fargo ($33; WFC) sees an improving housing market and appears positioned to benefit from that trend — mortgage banking accounted for 27% of its noninterest income in the nine months ended September. The bank says 40% of customers in its mortgage-servicing portfolio are strong candidates for refinancing, potentially boosting fees.

In October, Wells Fargo increased its repurchase authorization by 200 million shares, roughly 4% of the stock count. With a Value score of 84, Wells Fargo may be scooping up its shares on the cheap. At just 10 times trailing earnings, Wells Fargo trades 36% below its five-year average P/E ratio. The consensus projects per-share profits will rise 8% to $3.63 per share next year. And at just nine times that 2013 estimate, Wells Fargo trades at a 23% discount to the median bank in the S&P 1500 Index. Scoring above 85 in both sector-specific ranks, Wells Fargo is a Focus List Buy and a Long-Term Buy.

14 BIG BANKS
Below we list the largest banks in the S&P 500 Index. Stocks presented in green are followed by the Forecasts. Top year-ahead picks include U.S. Bancorp ($32; USB), Wells Fargo ($33; WFC), and Fifth Third Bancorp ($15; FITB). BB&T ($28; BBT) and J.P. Morgan Chase ($41; JPM) are Long-Term Buys. Citigroup ($35; C) is rated B, or average, and Bank of America ($10; BAC) is rated C, or below average.
--- Est. Current- Year ---
----- Est. Next-Year -----
Est. L-T
EPS
Growth
(%)
Price/Book Ratio
-------- Quadrix Scores --------
Company (Price; Ticker)
EPS
($)
Change
(%)
Est.
P/E
EPS
($)
Change
(%)
Est.
P/E
Recent
5-Yr.
Avg.
Momen-
tum
Value
Overall
Bank of America
($10; BAC)
0.42
4100
23
0.96
128
10
7
0.5
1.4
27
64
42
BB&T ($28; BBT)
2.69
47
10
3.02
12
9
10
1.0
3.3
71
87
72
Citigroup ($35; C)
4.19
15
8
4.64
11
8
10
0.6
1.4
22
89
52
Comerica ($30; CMA)
2.65
13
11
2.66
0
11
11
0.8
1.3
49
88
66
Fifth Third Bancorp
($15; FITB)
1.62
37
9
1.59
(2)
9
7
1.0
2.1
78
79
85
Huntington Bancshares
($6; HBAN)
0.66
11
9
0.66
(1)
9
6
1.0
2.0
52
85
65
J.P. Morgan Chase
($41; JPM)
5.03
12
8
5.35
6
8
7
0.8
3.0
76
92
95
KeyCorp ($8; KEY)
0.89
(3)
9
0.88
(1)
9
5
0.8
1.1
53
78
66
M&T Bank ($99; MTB)
7.56
19
13
8.21
9
12
9
1.4
3.5
87
60
85
PNC Financial
($55; PNC)
5.68
(6)
10
6.62
17
8
5
0.8
3.7
48
84
59
Regions Financial
($7; RF)
0.76
345
9
0.78
3
8
8
0.6
1.8
91
86
76
SunTrust Banks
($27; STI)
3.57
190
8
2.73
(24)
10
17
0.7
1.4
99
89
94
U.S. Bancorp
($32; USB)
2.87
21
11
3.08
7
10
8
1.8
7.7
90
69
90
Wells Fargo
($33; WFC
)
3.34
19
10
3.62
8
9
8
1.2
6.2
82
84
90
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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