Bank Stocks Rise as Loan Losses Decline


How do investors see the banking sector right now, and why are they buying bank stocks?

Most of the tone is fairly optimistic and bullish. You want to own bank stocks when you’re going through a credit recovery cycle. Mergers and acquisitions is another big theme that stimulates investor interest.

What are some of the factors that will drive bank stock valuations in 2011?

It’s early yet, but the names that are outperforming so far are those that still are seeing declines in nonperforming assets, declines in reserve levels and net interest margin improvement.

How will M&A drive stock values?

With valuations at trough levels for some decent banks, not specifically broken banks, but banks in good markets, with good deposit share, I think there is a great investment opportunity to own a basket of potential sellers.

How much M&A activity do you expect this year?

I expect considerable amount and even more in 2012 and beyond.  My outlook for the economy is still going to be low growth, especially for the banking sector.  Banks are going to have to grow through consolidation. They’re going to have to grow through collapsing the cost structure.

It’s been a couple of years since we had a strong M&A market.  Do you think investors still remember that not all acquirers are created equal and that an acquisition can destroy value if it’s not executed properly? 

We’re reminding investors about exactly your point. You want to be in a position to own the acquirers that have shown a track record of managing the capital base well, extracting earnings power, getting the costs out, and being mindful of the cultural differences within the banks.  I think this year will be a year where any M&A is almost good M&A, but a higher level of scrutiny will be placed on deals the further we get into this cycle.

How did investors react to the Dodd-Frank Act?

The elevated expense structure is probably going to prevent banks from achieving 15 percent return on equity or 1.5 percent return on assets, which they historically produced. You’re going to get volatility in the near term. Partially, that’s because we don’t really know what the profit model is going to look like for banks.

How do investors feel about the higher capital requirements for the industry?

Investors think the capital levels are too high, and they want to see these banks deploy it or leverage it as much as they can. The investment community has much more foresight and vision than the regulatory community. The regulators are looking in the rearview mirror and saying, “We need to build capital now.”  I think the investors have it right, quite frankly, and the regulators have it wrong.

In an environment like this, I thought we’d see more emphasis on efficiency.  I can remember a time, five to seven years ago, when there was a premium in your stock if you were a low-cost operator. Is this something that investors are focused on?

Banks are not very good in general about finding ways to cut the expense line when they see revenue decreasing. I would argue banks, in general, are still overstaffed. From a technological perspective, they still haven’t embraced efficiencies in processes and procedures. I think that’s a theme that’s not being talked about very much right now, but I think it will emerge as a much more important factor as we continue with low revenue growth.

Are there a couple of banks historically that have a reputation for being good low cost operators?

The one that comes to mind is (Paramus, New Jersey’s) Hudson City (Savings Bank). These guys operate at an 18 to 22 percent efficiency ratio.

Forward-Looking Statement

“With valuations at trough levels for some decent banks—not specifically broken banks—but banks in good markets, with good deposit share, I think there is a great investment opportunity to own a basket of potential sellers.”

Will 2011 be the year for bank stocks?


The bad news seems endless. Unemployment remains high. Bad real estate loans continue to hurt banks. Increased government regulation and caps on fees will hurt bank income in the future. And yet, so many bank analysts are so bullish on bank stocks in 2011.

Why?

Profitability is returning or will return this year to many mid-sized or small banks, several analysts say.

Stronger banks will be able to buy weaker rivals and grow market share. Even the investors of struggling banks stand to gain after years of misery. Their banks will get bought out at premiums compared to the disappointing prices of the last two years. 

Here is a review of what bank analysts are saying about the outlook for bank stocks in 2011 and their favorite picks:

mmosby.jpgMarty Mosby, a bank analyst at Guggenheim Partners in Memphis,
 says he thinks all of the 15 large-cap banks he covers will be profitable by the middle of this year and he projects a 30 percent stock market gain on average for his group, which includes Winston-Salem, North Carolina-based BB&T Corp., Atlanta-based SunTrust Banks, and San Francisco-based Wells Fargo & Co. 

“We believe 2011 will be the year of the recovery,’’ he says. “We will finally see banks return to the norm.”

Some banks will be better off than others in the new normal, of course.  Banks such as Wells Fargo & Co., Pittsburgh-based PNC Financial Services Group and New York-based BNY Mellon have revenue potential and strong capital, he says, which means they could buy other banks or increase dividends, always a plus for the many dividend-starved investors out there. PNC Financial Services Group reported today record profits of $3.4 billion for 2010.

Jim Sinegal, associate director of equity research at Chicago-based
Morningstar, Incexpects his top picks such as New York-based JPMorgan Chase & Co. and Wells Fargo to return 25 to 30 percent gains for investors. He hedges that a bit by saying it may happen in the next year—or two.

“We don’t see any surprises ahead that could derail something,’’ he says. “We’ll see a slow and steady improvement. Credit is slowly and steadily improving. A lot of banks already are benefiting from that. The worst loans on their balance sheets have already been charged off.” 

He even likes Charlotte, North Carolina-based Bank of America, even though other analysts are just too worried about an ongoing investigation into the bank’s foreclosure processes to recommend the stock. 

“We think the best values can be found in recovering banks,’’ he explains. “We think the stock is cheap.”

Bank of America was trading at $14.37 per share Thursday midday on the New York Stock Exchange.

jharralson.jpgJefferson Harralson, managing director in Atlanta for Keefe, Bruyette & Woods, says smaller banks might have a more difficult time seeing stock market gains this year than big banks. They could be hit hard by new regulations that limit fee income. New restrictions on debit card fees charged to merchants could limit that source of income by as much as 75 to 80 percent, he says. 

Plus, many small and even regional banks have not paid back the government for the Troubled Asset Relief Program money, which could weigh on stock prices this year as well. Investors worried the bank will be forced to raise more capital to pay back TARP won’t be eager to buy those banks.

kitzsimmons.jpgKevin Fitzsimmons, managing director at Sandler O’Neill & Partners in New York, says 36 percent of the group’s bank stocks have a buy rating, compared to 26 percent in January of last year. 

He also thinks there will be more risk in small bank stocks this year, because the heavy weight of regulation will move to smaller banks, as in rolling downhill, as regulators begin forcing those banks to recognize their problem loans.

“This is not going to be smooth going (for all banks),’’ he says. “(The market) will be selective.”

The good news is all that new regulatory pressure on small banks could lead more banks to sell out—for a premium this time.

Sinegal said recent acquisitions have netted prices at two times tangible book value for the acquiring bank, as opposed to no premium or 1.5 times book value during the last year.

“There is more optimism that the worst is behind us,’’ Fitzsimmons says. “There has been optimism that some banks will be able to go out and acquire more banks and the acquired banks can be bought at some sort of premium.”