Bank stocks favored by investors are few and far between these days. Despite improved earnings and more stringent safety requirements, the stocks of financial institutions have lagged behind the broader market in 2011. Weighing down their prospects are a slowly recovering economy and limited loan growth.
Many corporations that turned frugal during the recession don’t need loans because they are flush with cash, while a high unemployment rate means fewer consumers are in a position to qualify for loans.
Disturbing news about banking practices over the past three years also sapped the confidence that conservative investors once had in bank stocks.
“Banks are safer now than they’ve been in the past 75 years, with loan-to-deposit ratios in the best shape in 35 years,” observed Richard Bove, banking analyst for Rochdale Securities LLC of Stamford, Conn. “At the same time, the probability of interest rates moving up would drive the value of bank assets lower.”
In the wake of a huge first-quarter jump in earnings that was based on improved balance sheets, bank earnings should be extraordinarily strong for the next 12 to 18 months, he said. None of that improvement is reflected in share prices.
“For investors in large-cap bank stocks, the biggest frustration has been the banks’ inability to return meaningful capital to shareholders,” acknowledged David Honold, financial services analyst with Turner Investments in Berwyn, Pa. “Very important components of total return in the banking industry throughout the years had been dividends and share repurchases.”
That’s why Honold favors the stock of U.S. banks with unique niches or connections to overseas markets that are stronger than our own domestic market.
East West Bancorp Inc. (EWBC), a $20 billion asset California regional bank serving the Asian-American community with a network of 130 banking offices, is one of his favorite bank stocks. It describes itself as, “serving consumers and businesses throughout the U.S. and Greater China.” In its corporate lending it emphasizes small- to medium-sized businesses. Financially strong, it acquired competitor United Commercial Bank and has the capacity to increase its dividend or initiate a share buyback program.
“East West Bancorp does a lot of trade finance with China,” said Honold. “It is an example of a bank that occupies a position relatively insulated from what’s going on in the broader community.”
Citigroup (C), known by the public for the ignominy of its government bailout, is nonetheless a favorite stock of Honold because the bank derives more than half of its revenues from outside the U.S. It should benefit from superior prospects in countries such as Korea, Poland and Mexico with fewer regulatory restrictions than the banking industry faces here, Honold expects. Citigroup operates in 160 countries in credit cards, consumer finance, retail banking, corporate lending, investment banking and brokerage.
“The large banks that have survived the financial crisis will thrive because it created larger and stronger banks at the top of the industry,” said Honold. “As investors, we can say that we have more comfort about their balance sheet evaluations than we did three years ago.”
Banks are starting to release loan-loss reserves, an indication that they had put aside more money than they’ll need for expected future losses. That’s a clear sign that the industry’s credit quality has turned the corner, Honold is convinced.
“The good news is that the financial industry is in full repair mode, and the process continues as reserves are built and capital is replaced,” said David Ellison, president and chief investment officer for FBR Equity Funds in Boston. “The bad news is that the stocks have not done well this year.”
The dramatic fall in home prices is a major reason why the recession has been so bad, he said, since it has touched everyone in one way or another.
Nonetheless, the nation’s banks are much safer than they were three years ago because the profitability they exhibited then wasn’t real, he said. Banks are all about lending in good and bad times, said Ellison, but they turned into hedge funds, and when those hedge funds blew up, they took the entire economy down with them.
Today the big banks are in reasonably good shape because they are doing the right things to get better and that will pay off down the road, he believes. You could argue that one or another bank is six months ahead of the others, he said, but in the long run that doesn’t matter.
“I hate to pick favorite bank stocks because everyone says, ‘Well, Wells Fargo and JP Morgan Chase are in great shape, Bank of America is kind of in trouble and Citigroup has lagged,'” said Ellison, who believes we are in the portion of the economic cycle in which investors make money in bank stocks. “But you know, it doesn’t really matter because they are all doing the right things to get better and they will get better.”
To Bove’s way of thinking, investors should also consider a related segment of the world of money.
“Investors should focus on companies that grow their book value or units faster than the growth in inflation, which means companies tied to the growth in the money supply,” concluded Bove. “That would be stock of traders like Morgan Stanley (MS) and Goldman Sachs Group Inc.”
Andrew Leckey answers questions only through the column. Address inquiries to Andrew Leckey, 555 N. Central Ave., Suite 302, Phoenix, Ariz. 85004-1248, or by e-mail at firstname.lastname@example.org.