Promising Regional Banks For Patient Investors - Barron's

The news on the U.S. financial system may seem grim, but banks are mostly healthier than people think, says Barron's Andrew Bary. The banking industry is expected to be profitable next year, none of the major banks are likely to need bailouts, and regional outfits trading near book value could be a great buy for investors willing to wait out the downturn.

Banks have access to $250B of new government capital. With a 10:1 capital-to-assets ratio, $2.5T is theoretically available for lending. Of course, banks aren't lending nearly this much, and many are likely to use the cash for acquisitions instead of loans. Along with a tightened supply of credit, demand is likely to shrink as recession looms and consumers cut spending. Just as well, some would argue, since Americans are over-leveraged, with consumer debt at 100% of GDP and twice the level of the mid-1980s.

In Q3, bank loan losses rose to 1.6%, up from 0.8% as recently as Q4 2007. Analysts expect the default rate to continue upwards, possibly as high as 2.3% in Q3 2009, before levelling off, according to Kevin St. Pierre of Bernstein Research. Small and mid-sized businesses are frustrated by the tighter credit market, but banks are being understandably cautious as default levels rise.

Not all is so bleak, however. Stocks of strong banking institutions, including PNC (PNC), Wells Fargo (WFC), US Bancorp (USB) and JPMorgan Chase (JPM), have held up remarkably well in an otherwise downtrodden sector. Wells Fargo and PNC shares are up this year, while US Bancorp and JPMorgan have suffered considerably lighter losses than either the KBW Bank Index (-36%) or financial stocks in the S&P 500 (-47%) this year. Investors are betting these banks will be long-term winners as the banking sector continues to consolidate, but the stocks are still pricey compared to forecast earnings and tangible book value.

Despite the expected rise in loan losses, both major banks and regional banks are likely to remain profitable in 2009 as earnings more than offsets possible losses. Though the major banks listed above have done alright, it is the regional banks that hold the most promise, including Fifth Third (FITB), Marshall & Ilsley (MI), KeyCorp (KEY) and Synovus (SNV).

Synovus, Marshall & Ilsley and Fifth Third all trade near their tangible book values. With 2009 looking to be a rough year for earnings, St. Pierre suggests valuing stocks on tangible book value and 2010 earnings. He estimates Synovus could earn more than $0.90/share in 2010, up from an expected $0.25/share in 2009.

Fifth Third was once viewed as one of the country's best-managed banks, but tarnished that reputation with a series of overpriced acquisitions and bad investments. St. Pierre believes Fifth Third could earn $2.35/share in 2010, up from an expected $0.70/share in 2009. Currently trading just above tangible book at around $10, St. Pierre sees $17 as a reasonable price target. For Marshall & Ilsley, St. Pierre expects $1.44/share in 2009 and $2.75/share in 2010.

The financial sector has not yet regained its health, nor are the regional banks without their weaknesses. But for investors willing to look beyond the current crisis, a handful of regional banks hold great promise.

Comments

[Timmothy Posey:]

I'd add Regions Financial (RF) to that list. Great takeover target for one of the big majors, yet they still will be very profitable as a SuperRegional Bank in the Southeast

2008 Nov 02 02:45 PM

[Mr Mortgage:]

Banks are a mess with asset valuations represented on quarterly reports nowhere near their true valuations. I would agree with your analysis if the banks were reporting the true value of their assets. The problem with basing an analysis upon NEW lending is they still have to clean upon the trillions in bad loans before they will realize any upside from new. This runs across all assets classes. Remember, we are in an asset re-valuation period and the leverage comes out of the system. New loans pale in comparison to highly leveraged bad deals currently falling apart.

2008 Nov 02 04:14 PM

[Dork:]

Synovus and MI still have some of the highest exposures to toxic real estate construction and development in some of the worst areas of the country. Same with Regions (FL, GA). Fifth Third is often referred to in most circles as 5th Turd because of their weak management - a continual underperformer. Look at reserve levels, provisions to deal with elevated NPAs and NCOs are likely to remain high. They are trading at TBV for a reason.

2008 Nov 02 06:05 PM

[1worldcurrency:]

One question. You say banks "are expected to be profitable next year..."
Is that with the 700 billion dollar welfare program or without? Because others are lining up for their handouts, and they vote.

2008 Nov 03 01:04 AM

[dave mckay:]

Fifth Third bank got it's name in an interesting way. It's address was (is?) 3 Fifth St. in New York. And back in the prohibition days they wanted to name it Third Fifth bank, but that had too much of an alcohol connotation, so they reversed the name and it's been that way ever since.

2008 Nov 03 09:45 AM

[dc1:]

Hi Dave,

That was interesting. I have always wondered how it came up with that name, but, of course didn't take the time to research it. You just saved me the time. Thanks.

2008 Nov 03 11:55 AM

[bankshot:]

Fifth Third is based in Cinn. Ohio. The name comes from the merger of two large Cincinnati-based banks, the Fifth National Bank of Cincinnati and the Third National Bank of Cincinnati.

2008 Nov 03 04:00 PM

[nyka:]

McKay...thanks for the FITB background. Next, let's learn to differentiate between IT'S...WHICH MEANS IT IS; and ITS, indicating the possessive form.
You don't mean to write IT IS ADDRESS...do you? Or IT IS NAME? I don't think so, or at least I hope not.

2008 Nov 03 05:10 PM