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Out of the Brokers and into the Banks Greg Morcroft, MarketWatch 5-01 A convergence of economic and market forces is coming together and attracting investors to the big three U.S. banks, J.P. Morgan Chase, Citigroup and Bank of America. Bank stocks rose sharply Friday, and brokerage stocks fell, indicating that investors may be favoring banks, trading at relatively low valuations and sporting hefty dividends, over their brokerage cousins, which are trading near record valuations and prices. It's a textbook example of how good investors operate, buying low and selling high. Brokers have outperformed the bank stocks over the past two years as a flat yield curve took a greater toll on banks than brokers. And, with capital markets rising around the globe and a surge in commodities and hedge-fund businesses, brokers were printing money over the past several quarters, as firms like Lehman, Goldman Sachs, and Bear Stearns reported record earnings after record earnings. This may have prompted investors to ask themselves just how much better things can get. That kind of thinking keeps investors looking for a better opportunity, and they may now have found it in the banks. Those investors apparently got the signal they wanted last week as Fed Chairman Ben Bernanke laid the groundwork for an eventual pause in the steady upward move in interest rates. "[Friday's] upward move in large-cap bank stocks accompanied by a significant sell-off in brokers is clearly a result of Fed comments indicating it will step to the sidelines after many rate hikes," Merrill Lynch analyst Guy Mozkowski wrote in a research report Friday afternoon. J.P. Morgan and Bank of America were top performers last week, rising 6.8% and 6.5% respectively. Shares of J.P. Morgan Chase, Citigroup and Bank of America all posted healthy gains Friday after several analysts published bullish outlooks for the firms, citing strong capital-markets activity and international growth prospects as well as easing pressure from the recently flat yield curve. Analysts noted the shares were supported by high and secure yields and relatively low valuations. Piper Jaffray's Andrew Collins upgraded Citigroup shares to outperform from market perform, while Prudential Equity Group's Mike Mayo increased Pru's industry rating on money-center banks to neutral from unfavorable. And Goldman Sachs's Lori Appelbaum lifted her rating on U.S. large-cap banks to attractive, reflecting her view that the group tends to outperform as economic activity moderates, and bank earnings have become less cyclical in the face of rate and credit cycles. And research on Monday from Lehman highlights just how well the big banks have done after rate-hike cycles have ended in recent years. According to Lehman, banks have performed strongly after cuts cease. The firm said that in 1995, the big three banks, which had fallen 1% in the three months before the Fed ended a series of rate hikes in May of that year, were up 27% six months after the cuts ended, 65% after a year and 152% after two years. That compares with a rise of 102% for all banks over that same two-year period. And, during the three months immediately following rate hike cycles, the country's three largest banks have the best average short-term gains among bank sub-sectors going back to 1984, rising an average of 13% during the first three months following the halt of Fed hikes. Bank Stocks Offer Solid Long-term Gains with Little Risk Shawn Tully, FORTUNE 5-19 What bank stocks lack in glamour they more than make up in compelling numbers. The story comes in two parts. First, the biggest banks, from Citigroup to Wachovia, are paying rich dividends and are likely to increase them steadily, practically guaranteeing double-digit returns far into the future. Second, regional banks and thrifts are prime takeover candidates as the giants rush to expand - witness Wachovia's $26 billion deal for Golden West. Says Goldman Sachs analyst Lori Appelbaum: "Bank stocks don't look sexy until you look at the potential returns." For investors, the big diversified banks offer a rare combination: juicy yields plus significant earnings growth. And even though big-bank stocks are up 7% this year, they still sell at bargain prices. The five largest U.S. banks are Citi, Bank of America, J.P. Morgan Chase, Wachovia, and Wells Fargo, boast an average dividend yield of 3.6%. That's twice the yield of the S&P and not too far behind the three-year Treasury yield of 4.9%. Since dividends are paid from earnings, they typically increase in step with profits. Over the past four years the big banks (excluding J.P. Morgan) have raised earnings at double-digit rates. Result: BofA's dividend has jumped 14% a year since 2001, while Wells' has posted annual increases of 19%. Let's be cautious and project that the big banks' earnings growth averages to 8% over the next seven years, far below the recent level. So dividends should also grow at 8%. But while paying out around 46% of their annual profits in dividends, they're typically using another 20% or so of their earnings to buy back stock. It's a safe bet that they'll keep buying back about 1.5% of their shares annually. Since both earnings and dividends will be spread across fewer shares each year, the dividends per share will rise not by 8% a year, but by more like 9.5%. The banks are using two-thirds of their profits to pay dividends and buy back stock, which means they're retaining only one-third to invest in growing their business. But that's all they need, because banks generate huge returns, both on the capital they already have and on the new money flowing in as retained earnings. The proof: On average, the four most profitable big banks boast a sumptuous return on equity of 16.5% over the past five years, vs. an average of 12% for stocks in the S&P 500. Now let's get back to the payoff for investors. You're starting with a 3.6% dividend. It's rising at almost 10% a year. So in 2012, you'll be receiving 6.8%, not 3.6%, on your original investment, and the payouts will ratchet upward from there. The dividend payments are just part of your return. If earnings per share keep rising at 9.5% annually, the banks' stock prices will increase at the same rate (assuming the relatively low price/earnings multiples remain constant). Your returns should start in the 13% range - the 3.5% current dividend plus a 9.5% capital gain. But in seven years, thanks to the ever-growing dividend, that number should surpass 15%. J.P. Morgan has the potential to deliver even greater returns. To buy the stock now, you have to believe that new CEO Jamie Dimon will be able to turn the bank around. If that comeback happens, the dividend - and the stock price - could soar. Unlike its big rivals, J.P. Morgan hasn't increased its dividend in five years, chiefly because it's been saddled with weak earnings. Dimon has been expanding in lucrative areas like credit cards and energy and mortgage-backed security trading to increase profitability. If those moves manage to raise J.P. Morgan's ROE from 8% to its peers' 16.5% average, the dividend will double along with earnings, giving investors who got in early an enormous yield of around 6% as well as a big capital gain. Is there any risk in these equations? Of course. J.P. Morgan's comeback could stall, and the other banks' share prices could flatten or drop, saddling investors with little more than the single-digit returns provided by dividends. That's possible, but unlikely. The reason: Bank stocks still look cheap. On average, Citi, BofA, Wells, and Wachovia have P/Es of just 12.4. That's far lower than the multiples in the other big-dividend-paying sectors - pharmaceuticals, utilities, and telecom - even though the banks' earnings are growing just as fast as profits in those three industries. In fact, it's more probable that banking multiples will rise to the 15 or so that prevails in the other big-dividend sectors, adding a big kicker for shareholders. Investors can play the banking market a second way, by predicting which regional and smaller banks and thrifts the big boys are likely to buy. Today retail banking is highly fragmented: The big five control just 28% of nationwide deposits. "We'll see tremendous consolidation in the industry in the next few years," says Meredith Whitney, an analyst with CIBC World Markets. The key is geography. Several of the giants have gaps in their footprints. J.P. Morgan and Citi, for example, need to establish big footholds in Florida and California, while Wachovia covets more branches in the West. Among the best candidates: SunTrust, which is a powerhouse in Florida and Georgia, where Citi and J.P. Morgan need to grow. PNC is a major player in Pennsylvania and New Jersey, which are among the nation's wealthiest markets. U.S. Bancorp boasts a solid franchise in the Pacific Northwest, California, and Colorado. Washington Mutual would hand a buyer 2,200 branches across the country, including a strong presence in California. Watch the banks. As a famous bank robber put it, that's where the money is. Credit-Card Issuers' Problem: People Are Paying Their Bills Robin Sidel, WSJ 5-25 The credit-card industry has a problem: Although Americans are deeper in debt than ever, they are paying off bigger portions of their monthly credit-card bills. For card issuers, which profit by collecting interest on unpaid balances, that's bad news. In the past, when interest rates crept up, as they are doing now, fewer cardholders could afford to pay down balances. "Normally at this point in the economic cycle, you start to see payment rates decline. But that's not happening," says Richard Srednicki, who runs the credit-card business at J.P. Morgan Chase & Co., the nation's second-largest card issuer. "It is a tougher business if payment rates continue to stay up and consumers continue to pay off more. It's something we've got to understand and work at." Although consumers are using plastic for more of their daily purchases, they are giving card issuers fits by juggling their debts more shrewdly. When cardholders are hit with high interest rates on one card, they routinely transfer balances to new cards at lower rates. And in recent years, as real-estate values soared and mortgage rates fell sharply, more consumers wiped out credit-card debts altogether by borrowing against their homes. To make matters worse for card issuers, federal bank regulators issued new guidelines in 2003 meant to ensure that cardholders pay off more each month than just the fees and interest charges that have accumulated. To comply with the rules, many banks have raised minimum-payment requirements, bumping up the payment rate further. In March, U.S. cardholders paid down 20.6% of total credit-card debt, up from 17.9% a year earlier, according to an analysis by Barclays Capital of one portion of the market -- $400 billion of credit-card debt sold to investors as securities. That was the highest payoff rate in the five years tracked by Barclays. According to the Federal Reserve, during Q4-05, consumer debt, which includes credit-card debt and auto leases, represented 5.71% of total homeowner debt, down from 6.4% in Q4-00. That was the lowest level in a decade. American consumers have not curbed their appetites for borrowing. During Q4, 13.86% of disposable personal income of Americans was consumed by debt payments of all kinds, up from 12.77% five years earlier. But an increasing portion of that total went to mortgages and home-equity loans, which ballooned in recent years as rates fell. Now, rebounding mortgage rates could provide relief to credit-card issuers, because they will make it less advantageous for cardholders to consolidate debts with home-equity loans. But the new credit-card minimum-payment guidelines could negate some of that benefit to card issuers. Last year, banks notched pretax profits of $30.6 billion on credit-card operations, down 3% from the year-earlier period, the first such decline since 1998, according to CardWeb.com, a closely held firm that tracks the industry. The after-tax return on average assets -- one measure of industry profitability -- was 1.21% at year-end, down from 1.48% a year earlier, CardWeb reports. Card issuers are trying to replace lost interest revenue by increasing late-payment fees and raising interest rates for customers unable to pay their bills in full. In an effort to build customer loyalty and increase spending, issuers have launched a slew of new cards and have introduced new checkout-counter technologies to encourage more card use. They have spent billions of dollars to grow through acquisitions, buying rival card issuers and specialized credit-card portfolios from retailers. At Citigroup, credit cards accounted for about 17% of the bank's $24.59 billion of net income last year. Sallie Krawcheck, Citigroup's CFO, told investors and analysts last month that Q1 revenues fell 6% in its U.S. card business. More consumers are using cards that emphasize rewards programs, which she said are more likely to be paid off each month. April Ratings Changes On 4-18 Friedman Billings Downgraded RF from Outperform to Market Perform. On 4-06 Keefe Bruyette Initiated coverage of USB at Market Perform. Do All Banks Have Moats? Jim Callahan, CFA MorningStar 5-01 You might be surprised to hear that nearly all banks have a sustainable competitive advantage--an economic moat. Warren Buffett and Charlie Munger were surprised, too. Buffett once remarked, "Charlie and I have been surprised at how much profitability banks have, given that it seems like a commodity business." At Morningstar, we've long recognized the moats of banks, and it's nearly impossible to understate their importance. Without a robust analysis of a company's competitive advantage and the sustainability of that advantage over time, investors run the risk of buying one-hit wonders that burn out fastalong with shareholders' money. At Morningstar, we begin each new analysis with the idea that a company has no economic moat until one is proven. But our financial services team believes that the banking industry offers an exception to the rule. We would argue that every bank has, at a minimum, a narrow economic moat. To review some fundamentals, an economic moat represents a company's ability to earn returns above its cost of capital and defend its ability to do so over time. After confirming that a company's historical returns on invested capital exceed its cost of capital--the easier task--one must assess the likelihood of those surplus returns persisting in the future, and here's where mistakes can be made. The Beauty of the Deposit-Gathering Business We believe that the true value in the banking industry is in the deposit business. The cost of banks' deposits can vary widely, ranging from market-rate-bearing deposits to non-interest-bearing deposits. This is because deposits, unlike any other form of debt, can generate revenue. (Imagine being paid to take out a mortgage!) When factoring in the income generated from deposit service fees (think ATM charges or overdraft fees), some banks are actually getting paid to hold depositors' funds. Consider this: Banks can borrow money more cheaply than the U.S. government. The U.S. government is known as a risk-free borrower and, therefore, should command the lowest interest rates on its borrowings in the market. Of the largest banks by asset size, we found a 5-year average effective deposit cost (interest costs net of deposit service fees) of 1.14% compared to a 2.13% average short term Treasury bill over the same time period. In fact, a full 87 of the 113 banks (77%) we analyzed boasted average effective deposit costs below that of Uncle Sam's borrowing rate since 2000, while six banks actually generated deposit fees in excess of their deposit interest costs. Some of the more attractively funded banks we cover, as measured by their average cost of deposits over the last five years, include TCF Financial, Provident Bankshares, and Cullen/Frost Bankers. The Advantage of Regulation We believe that the heavy regulation of the past provided many banks a head start toward their dominant market shares. After the Great Depression, the banking industry became highly regulated. Banks were essentially granted government licenses to operate their depository and lending operations within a specified state or even county. Further, banks were required to pay depository insurance, allowing the government to guarantee bank customers security from bank runs. The result was that, for any given operating area, one bank dominated the market, had barriers protecting it from new entrants, and was given below-market funding due to the risk-free nature of the deposit business. As long as the bank's borrowers didn't default, it was almost guaranteed a profit based upon the spread earned between the cheap funding and the interest rate on its loans. Further, since the industry became highly fragmented, numerous banks--each operating within their own small market - often had loan officers and customers that developed deep relationships that lasted for years. Over the decades, of course, things have changed. Banks can apply for a charter to operate in any state and can engage in many nonbanking businesses, such as investment banking, asset management, and insurance brokerage. But the foundation upon which the industry was formed is still present. The banks that dominated certain cities 75 years ago remain (in various forms) today. Think of Wells Fargo in San Francisco, Fifth Third in Cincinnati, and Washington Mutual in Seattle. We believe that this stems from banks' integral roles within their respective communities: In assessing risk, they must know a borrower well, and in making loans, a bank is essentially financing the growth of a community over time. Switching Costs On a related note, we'd highlight the surprisingly high switching costs in the industry. Now at first glance, it would appear easy enough to switch accounts from one bank to another. However, on average, deposits have proven to be fairly "sticky." The development of alternative distribution channels--first ATMs, then in-store branches, then Internet banking---have made banks more accessible to customers. This availability lowers the chance of a customer leaving simply because a competing bank's branch is more convenient to, say, the workplace or school. Online bill payment and automatic direct deposits further increase a deposit account's "stickiness." It can be tedious setting up payees and dollar amounts upon initiating an online bill payments, making the thought of switching to another bank and having to go through the process again somewhat of a mini-barrier to exit. (We say mini-barrier because, as we speak, various technology firms are developing software to help transfer such information from one bank to another with the simple click of a button.) The bottom line is that the average life of a deposit account is surprisingly long, offering banks more opportunities to earn the spread between its borrowing and lending activities. A Caveat: International Banks The U.S. market is a somewhat of a special case. Our comments thus far have focused on the U.S. banking industry, and the biggest difference when looking beyond the domestic banking market is that, unlike in the U.S., many countries' banking industries are largely consolidated. In fact, the U.S. ranks as one of the most fragmented banking industries in the world. Although the moat characteristics we've described broadly apply to the international banks we follow, there are exceptions to the rule, and we'd advise thorough research prior to investing internationally. (See our two-part article from January on how we approach investing in international banks.) Conclusion Banks are good businesses because of their fundamental design. Although many believe that banking is a commodity business, we believe that the basic business of banking and the industry's average profitability tell investors something different. Simply put, the proof of the industry's narrow economic moat is in the numbers: The average bank over the last 15 years has generated a 13%-14% tangible return on equity, above our 10%-11% estimated cost of capital. Those are the kind of numbers that turned the heads of Buffett and Munger. A quick review of Morningstar's bank coverage reveals 59 domestic banks and 29 international banks. Of the domestic banks, 49 have narrow moats and 10 have wide moats. Currently, we believe the best investment opportunities are in large-cap, wide-moat banks, and we encourage investors to take a closer look. Huntington Bancshares Announces 6 Million Share Accelerated Share Repurchase PRNewswire 5-25 Huntington Bancshares announced the repurchase of 6.0 million shares of common stock, or 2.4% of its shares outstanding as of March 31, 2006, from Bear Stearns under an accelerated share repurchase program. The initial price paid per share was $23.42 for an aggregate payment of approximately $140.5 million. The 6.0 million shares repurchased under the accelerated share repurchase program are in addition to 2.1 million shares repurchased in the open market after March 31, 2006 through May 19, 2006. Regions to Merge With AmSouth Berman & Bauerlein, WSJ 5-25 Regions Financial last night struck a $10 billion deal to combine with its hometown rival AmSouth Bancorp, as the two Birmingham, Ala., banks gird for competition with national giants that are themselves growing larger. The deal comes as banks and other financial institutions confront rising interest rates that are likely to crimp their profits and slow the booming home-mortgage business. Regional banks like Regions and AmSouth are also scrapping for consumer deposits against big players such as Wachovia and Bank of America, which are pushing ever deeper into territories that were once the province of regional stalwarts. The combined Regions and AmSouth would become the nation's 10th-largest bank as measured by market capitalization. And it would wield new clout across the South, where its combined 2,000 branches would spread across several states, including high-growth markets such as Florida and Texas. The combined bank would hold about 30% of all deposits in Alabama, and rise to No. 4 in market share in Florida, according to FDIC data. AmSouth Chairman and Chief Executive Dowd Ritter would take the chief executive post at the new company, while Regions Chairman and CEO Jackson Moore would be chairman. For each of their shares, AmSouth shareholders would receive 0.7974 share of Regions stock. Based on Regions' closing price of $35.53 yesterday, that's $28.33 for each AmSouth share -- 2% below yesterday's AmSouth close of $28.90 a share. That makes the deal a "take-under," meaning that shareholders get a price below the current market value. While the deal is also being described as something of a "merger of equals," it is clear that Regions would have the bulk of the power, having a $16 billion market capitalization, compared with AmSouth's $10 billion. Regions would also have more seats on the company's board, people familiar with the matter said, and the new bank would carry the Regions name. Take-unders are often difficult for shareholders to stomach, because holders typically want to be rewarded for ceding control of a company. For such a deal to win the market's blessing, investors would have to believe that the two banks could significantly cut their costs -- and that the benefits would trickle down to shareholders. They must also believe that another suitor wouldn't have paid more than what those cost cuts are worth over time. That does create some risk for the Regions deal, as an unsolicited bidder could step into the fray offering a bigger initial payout. Last Friday, Citigroup banking analyst Keith Horowitz estimated that AmSouth could sell for $30 to $32 a share, or $36 a share in a best-case scenario. The banks are targeting cost savings of about $400 million annually, people familiar with the matter said. That's equivalent to more than 20% of their combined net income for the past 12 months, according to figures compiled by data provider CapitalIQ. May Ratings Changes On 5-26 Prudential Downgraded SNV from Overweight to Neutral. On 5-25 Lehman Cut Associated Banc-Corp To Equal Weight. On 5-18 Ryan, Beck & Co Downgraded FMER from Market Perform to Underperform. April Ratings Changes On 4-19 Friedman Billings Upgraded ASO from Market Perform to Outperform and Sandler O'Neill Upgraded ASO from Sell to Hold. On 4-10 CIBC World Markets Upgraded ASO from Sector Underperform to Sector Perform. On 4-21 Ryan, Beck Downgraded ASBC from Outperform to Market Perform, Friedman Billings Downgraded ASBC from Outperform to Market Perform, and KeyBanc Capital Mkts / McDonald Downgraded ASBC from Aggressive Buy to Buy. On 4-04 Ryan, Beck & Co Initiated coverage of CMA at Market Perform. On 4-20 Friedman Billings Downgraded CYN from Outperform to Market Perform, Sandler O'Neill Downgraded CYN from Buy to Hold, Sanders Morris Harris Downgraded CYN from Buy to Hold, Ryan, Beck Upgraded CYN from Market Perform to Outperform and Lehman Brothers Upgraded CYN from Equal-weight to Overweight. Home Page Factoids Previous Update |