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More than four years since we saw name-brand financial institutions blowing up and taking the global economy down with them, the public still has a major distrust of the big banks. The sector as a whole (XLF) trades at 13.5 of 2013 estimated earnings. This is a 10% discount to the broader S&P's (SPY) 2013E earnings, and is the second most cheaply valued sector next to energy. Individually, names like Citigroup (C), Wells Fargo (WFC), and JPMorgan (JPM) trade at even deeper discounts to the forward multiple of 15 on the broader market with P/Es in the range of 9 to 11.

Some of this is indeed justified. I've discussed the factors that will make banking somewhat less lucrative going forward compared to five or six years ago. These headwinds are well-documented, and with valuations so low on a relative basis, they also seem to be well-priced.

Income generation has probably been the hottest topic since the 10-year note yield headed below 3% in 2011. With the big boomer population entering retirement, the desire for income-producing assets has been relentless, and it seems like this dynamic has resulted in a subsequent lack of long-term thinking.

Desperate for yield (and safety), investors have piled into utilities (XLU) and consumer staples (XLP), with a seeming disregard for the prices they're paying. These sectors typically grow at 3-4 and 6-8% historically and respectively, and yet here they are at significant premiums to the broader market. Though the dividends are safe at most utilities and consumer staples' firms, the risk of capital loss in these securities is meaningful considering the hopeful valuations.

This deficiency of long-term thinking, generally as a result of focusing mainly on the annual distributions of safe stocks, has created an opportunity for savvy dividend growth investors in the stocks of major financials.

Big Bank Dividends Are On The Way

It's easy to forget that most of these banks were paying near 3% dividends before the crisis. Though they ended up diluting (so the comparisons are skewed), Citi was paying $2.16 a share annually. BofA paid $2.56, WFC $1.36, and JPM paid $1.52.

WFC and JPM, fresh off of strong Fed stress test data, have restored their dividends to the record levels set in the glory days of 2006-2007. Though Citi recently got approval for a modest share buyback, the company is still stuck paying a measly $.04 annualized dividend, as is BofA.

Regarding WFC and JPM, it's important to remember that both these companies earn more money per share today than they did in 2007, and they're doing it with better capital ratios and higher book values.

In 2007, the last time JPM was paying $1.52 a share annually, the bank was earning $4.52 per share and had a book value of $36.59; Tier 1 capital was 8.4. This amounted to a payout ratio of 33.6%. Current 2013 earnings estimates are calling for $5.70 in EPS, resulting in a payout ratio of only 26.6%. 2013 Q1 book value/share was around $52, while Tier 1 capital was 9.6%.

Assuming a "normalized" payout ratio of 35% - quite plausible given the vastly improved and conservative balance sheet - JPM would be paying $2/share annually, or 3.7%. With EPS projected at $5.94 in 2014 and modest long-term growth of 4-6%, the yield on cost for shares of JPM should be close to 4% by 2015.

The same calculation done for WFC yields similar results. In 2007, the bank paid $1.18 per share, relative to $2.38 in EPS. BVPS (book value per share) was a mere $14.45, and the Tier 1 capital ratio was a lowly 7.59. In Q1 2013, BVPS nearly doubled from 2007 levels to 28.26, while Tier 1 capital came in at 11.79%. EPS for 2013E is $3.71, relative to $1.20 in dividends - a 32.3% payout vs. the near 50% payout ratio achieved in 2007. I have included the Tier 1 capital ratios to indicate the vastly strengthened balance sheets, which over time (given Fed clearance) will allow these banks to attain similar, if not higher payout ratios then we saw in 2007.

WFC pays a 2.9% dividend as of now, which is still a meaningful premium to the risk-free rate offered by the 10-year Treasury. When considered in conjunction with the 8.9% earnings yield, the expected forward returns are vastly superior to the comparable "risk-free" alternative available via government bonds. Adjusting for say, a 45% payout ratio, WFC would be paying 4%.

Investors in BofA and Citigroup are still a year or two away from even getting a taste of the good 'ol days, but even compressed adjusted payout ratios of 25% would result in 2013 dividends of 2-2.4%.

Conclusions

It's going to be quite some time before yield-seeking investors consider the big money-center banks as pillars of a good income portfolio, but I believe these names are well on their way to being just that. The two best banks, at least in my opinion, should generate YOC (or yields on cost) of 3.7-4% by either year-end 2014 or 2015, and the further expansion of payout ratios is quite possible given higher capital levels. Furthermore, it seems reasonable to expect at least 4-6% EPS growth, so subsequent annual dividend increases in-line with EPS growth will outpace inflation and reward dividend growth investors with superior income.

Given the catalyst of Fed clearance and the likelihood of substantial expansions in payout ratios, I don't think there is a better sector for dividend growth for the remainder of this decade. The relative discounts that these equities offer is just the icing on the cake.

Source: Big Banks: This Decade's Best Sector For Dividend Growth