By Carla Fried
At the halfway mark for second-quarter earnings season, the financial sector is clearly doing the heavy lifting in keeping the S&P 500 from a very ugly turnout. According to Factset, the 1.8% earnings growth rate for the benchmark index would sink to -2.9% if not for the strong performance of the financial sector. Led by stronger-than-expected earnings from the likes of JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) the financials' earnings growth rate has come in at nearly 11% ahead of what the street expected. The only other strong upside surprise sector has been healthcare at +7.2% according to Factset.
As this chart clearly shows, the strong showing in the first and second quarter hasn't gone unnoticed. Amid the backdrop of a very strong 18% gain for the S&P 500 so far this year, the big commercial banks have done even better:
JPM data by YCharts
Chris Lee, manager of the $680 million Fidelity Select-Financial Services mutual fund - up 35% over the past 12 months - is out with a report that suggests bank stocks still offer a compelling story going forward.
Despite the impressive stock gains, it's not hard to find valuations well below the market. JP Morgan, Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) currently trade at forward price/earnings multiples below 12, compared to the 15.4 estimate for the overall S&P 500.
Lee also points out that many banks still trade very low - WFC and Citigroup currently trade at price/book value levels.
JPM Price / Book Value data by YCharts
Of course there's the semi-permanent elephant in the investing room: are they really worth taking the risk, given the not-too-distant memory of how the bank industry pulled not just the markets but the economy to the brink during the financial crisis?
Lee points to a much stronger balance sheet: according to his calculations the average commercial banks equity/assets ratio has improved from 9.4% in 2008 to more than 11.1% today. The historic norm is 7.5%.
Next up he points out banks' average 1% return on assets (ROA) now exceeds the historical average of 0.8%. Lee tends to do a lot of tactical trading - turnover for the portfolio is nearly 300% a year - but as of the end of June we know that his top five holdings - accounting for about 24% of fund assets - were Citigroup, JP Morgan, Wells Fargo, Bank of America and U.S. Bancorp (NYSE:USB), which is the fifth largest bank in the country.
As this chart shows, Wells Fargo and U.S. Bancorp are the ROA standouts.
JPM Return on Assets data by YCharts
It's probably not a coincidence that both Wells Fargo and U.S. Bancorp also happen to be among the largest stock investments of the quality focused Berkshire Hathaway (NYSE:BRK.B) portfolio.
Lee makes the case that one clear reason for the relatively low valuations for commercial banks is their muddied dividend story. Forced to reduce payouts during the financial crisis, the big boys' dividend policy today must pass muster with the Federal Reserve: dividend increases are granted based on each bank's stress test showing. Over the past three years, Wells Fargo and U.S. Bancorp are, again, the standouts in terms of dividend growth.
WFC Dividend data by YCharts
Given improving balance sheets, Lee surmises the dividend payout ratios for the banks should continue to rise; the average right now is 24%, barely more than half the historic norm of 46%. And that potentially spells a double opportunity, according to Lee: "As the payout ratios of banks return to pre crisis levels, bank stocks have the potential for upward revaluation. Going forward, bank stocks thus could offer a desirable stream of dividend income in addition to capital appreciation," he wrote in his sector report.
On the payout front both Wells Fargo and U.S. Bancorp have payout ratios below 30%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.