Don't Bank On It
The guarantee “You can take it to the bank” doesn’t mean as much these days as it once did.
While the S&P 1500 Bank Industry Index gained more than 25% from its early February low to mid-April highs, the index has since given back most of those gains. Even after the recent retreat, the index has jumped 23% over the last 12 months. However, the rally has not erased investors’ memories of frightening declines in 2007 and 2008. The pressures of the credit crunch have eased in the U.S., but troubles in Europe serve as a constant reminder that we have not yet returned to the glory days. In particular, some of the largest U.S. banks, the ones that generated so many of the ugliest headlines during the downturn, are far from healthy.
The sector as a whole underperformed the market by a wide margin both in the year ended May 2009 and the year ended May 2008, so much so that the strong performance in the year ended May 2010 hasn’t come close to erasing the losses. But even at a fraction of their former size, the big banks still carry a lot of weight in the sector.
What’s a bank?
In recent years, the line between banks and nonbank financials has blurred, as a wave of acquisitions left many companies cooking in different kitchens. In late 2008, some brokerages like Goldman Sachs ($142; GS) and Morgan Stanley ($26; MS) and consumer-finance concerns such as American Express ($39; AXP) got themselves classified as banks, in large part to allow them access to federal bailout funds. For the purposes of this story, the eight largest banks are the three listed in the last sentence, Bank of America ($15; BAC), Citigroup ($4; C), J.P. Morgan Chase ($39; JPM), Wells Fargo ($28; WFC), and U.S. Bancorp ($23; USB).
The Big 8 have a combined market value of $786 billion, down 31% from $1.10 trillion three years ago. But while the companies are smaller than they once were, they still have a huge effect on the market. The eight companies make up 40% of the stock-market value of the S&P 1500 Index’s financials sector, versus 34% three years ago. The financial sector represents nearly 17% of the market value of the entire S&P 1500 Index.
Not yet time to buy
On average, the eight companies are expected to deliver per-share-profit growth of 40% this year and 36% next year. But despite that growth, we’re not quite ready to buy. Here are four reasons for caution:
• Weak fundamentals: The Big 8 average Quadrix® Overall scores of 51 and similar mediocrity in our sector-specific scores designed to compare financials to other financials.
• Finance reform: The specter of tighter regulation and other political risks weighs on the big banks. The Senate passed a financial-reform bill, and bank shares rose on the news, most likely because the potential changes were not as draconian as many feared. However, the industry will likely face far more scrutiny in coming years.
Among the measures under debate as the House of Representatives and the Senate attempt to forge a compromise bill are provisions that would reduce or restrict banks’ abilities to trade derivatives, limit how big banks can grow, and allow the government to take over failing companies.
• Global troubles: A flurry of U.S. corporate-bond issuance in May suggests that fears of a spread of the European credit contagion to this country have diminished a bit. But many industry watchers expect more bad news on sovereign debt overseas. And even if we have seen the worst of the credit problems, slow growth in Europe and continued weakness in the euro could stunt growth at all U.S. multinationals.
• Company-specific woes: The Securities and Exchange Commission has sued Goldman Sachs over mortgage securities it allegedly designed to fail. In addition, New York has launched a criminal investigation of six big banks, including J.P. Morgan, Citigroup, Goldman, and Morgan. Similar probes could crop up in other jurisdictions.
The Big 8 banks are listed in the table below. In the following paragraphs, we review four of them, and in Analysts' Choice we review insurers Aflac ($43; AFL) and Travelers ($49; TRV), the only financials we currently recommend for purchase. And at www.DowTheory.com/Go/Finance, we present data on every financial stock in the S&P 1500 Index.
Despite a 38% return over the last 12 months, Bank of America ($15; BAC) has lost about a third of its value over the last three years. Yet with a stock-market value of more than $154 billion, Bank of America is still the second-largest U.S. financial company. It is also among the most diversified companies in the industry. Bank of America, Citigroup, and J.P. Morgan are the only three components of a subindustry group called “Other Diversified Financial Services.” Their operations span the breadth of the financials sector and defy a more precise classification.
In 2009, consumer and small-business banking accounted for 12% of revenue, while credit cards generated 24% of revenue. Other business units include home loans and insurance (14% of revenue), corporate banking (19%), investment and trading services (17%), and wealth management (15%). Few other banks have amassed such a diverse business mix, and with tighter regulation of the industry in store, membership in this club is probably closed. Credit quality has improved at Bank of America in recent months, just as it has at the other big banks, but nonperforming assets still represent 1.5% of all assets, triple the average of 0.5% over the last 10 years.
Bank of America topped consensus expectations in the March quarter, mostly on strength in the notoriously fickle trading business, and Wall Street expects per-share profits of $1.03 this year and $1.92 in 2011. However, revenue-growth expectations are modest, in part because of legislation — some enacted and some still under discussion — limiting credit-card interest, overdraft fees, and derivatives trading. The stock earns a Quadrix Overall score of 18 and does not look particularly cheap relative to its peers or its history. A combination of questionable fundamentals and an uncertain outlook earn Bank of America a C (below average) rating.
Citigroup ($4; C) has lost more than 50% of its stock-market value over the last three years. The Overall score of 20 tells a disappointing story about a fallen giant. The company is still huge, generating more than $104 billion in revenue over the last 12 months. But it has earned a profit in only two of the last 10 quarters. The stock looks cheap at nine times projected 2011 earnings, but analyst profit estimates vary greatly, and the Value score of 28 reflects the fact that Citigroup looks expensive based on other valuation ratios. Our advice is to avoid Citigroup, which earns a rating of C (below average).
J.P. Morgan Chase ($39; JPM) earns fairly high Quadrix scores (74 Overall, 81 Value, and at least 77 in both sector scores). Its balance sheet is stronger than that of its largest rivals, but charge-offs and huge losses from the home-equity-loan portfolio purchased from WaMu continue to weigh on J.P. Morgan. Last year, the company generated 42% of its revenue from retail and corporate banking, 26% from investment banking, 19% from credit cards, and 13% from asset management and investments. The consensus projects per-share-profit growth of 43% this year and 48% next year despite roughly flat revenue. J.P. Morgan looks like the strongest of the big financial conglomerates and earns a B (average) rating.
Goldman Sachs ($142; GS) scores 89 or higher in Overall, Value, and both sector-specific Quadrix scores. Over the last four quarters, the brokerage has earned about $24 per share. The consensus projects profits will fall 12% in 2010 and rise 6% in 2011, though a wide range of estimates reflects uncertainty about both the sector and the company’s high-profile legal battle. The Securities and Exchange Commission has charged Goldman with fraud, and the broker would score a coup if it can settle the matter by paying a fine and admitting to lesser malfeasance. Goldman looks cheap relative to its peer group and its history as measured by several metrics, but the SEC lawsuit adds an uncomfortable amount of risk to the shares, which are rated B (average).