Interest rates are set to rise for two reasons in 2014. First, the Fed's tapering, expected to be at $10 billion per meeting, will drive the overall level of yields up and steepen the yield curve. Second, a pickup in the U.S. economy will also cause an increase in interest rates. This slow rise in interest rates (particularly for the longer maturity bonds) will benefit the banks, which will earn more interest on their loans. Moreover, as a higher beta sector, the financials are set to benefit from an appreciation of the S&P 500. These arguments are not new, but interest rates have yet to react to their fullest extent. This is because the Fed still makes up the majority of new U.S. government bond issues; regulations require banks to hold a certain amount of government debt; and diversified funds still need to buy fixed-income products to meet their investment objectives. This delay in the rise in interest rates points towards higher bank stock prices in the future. I will use several methods to determine which bank is best positioned for these increasing rates. However, a good company does not make an attractive stock. Thus, other comparisons will be used to predict which stock is set to appreciate the most. An outline for my analysis is listed below:
- Revenue growth and margins
- Discounted earnings before taxes
- Price to earnings comparisons
- Return on assets
- Return on equity versus price over book value
- Allowance for loan and lease losses and net charge-offs
- Returning value to shareholders
The banks that will be analyzed are Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS), U.S. Bancorp (NYSE:USB), and Wells Fargo (NYSE:WFC).
1. Revenue growth and margins
To find out which bank has the best exposure to rising interest rates in terms of interest revenue, three methods are used. The first is analyzing simple interest revenue growth and margin trends. The second is to look at the correlation between the historical 10-year U.S. treasury yield and interest revenue growth. The third is to then analyze the spread between changes in the 10-year yield and interest revenues.
Interest Revenue Growth
* 2013 starts in 3Q2012 and finishes in 3Q2013, when the most recent 10-Q was filed.
USB, in 2011 and 2012, has actually been able to increase its revenues. However, as yields continued to fall in 2013, USB's revenues also decreased, but at a much lower rate than most its peers. WFC has also had success in mitigating its revenue losses amid decreasing bond yields.
Moreover, USB and WFC have been able to take advantage of high and growing gross interest margins since 2010. Also notable are BAC and C's rising interest margins, which may lead to further bottom-line growth in the future.
Interest revenue growth minus change in 10-year yield
This method took the average spread between quarterly interest revenue growth and changes in the average 10-year yield since 2Q2010. Once again, USB and WFC showed their strength in their interest income-generating divisions. Their ability to continuously maintain higher interest revenues, net of any changes in bond yields, shows those banks' competitive advantage.
Correlation between yield and revenue growth
Similarly, USB and WFC have had the lowest correlation between yields and interest revenue growth. That is, USB and WFC were able to mitigate the decline in banks' lending businesses as bond yields decreased from 2010 through 2012. Thus, USB and WFC's interest earning divisions are also strongly positioned in decreasing rate environments.
USB and WFC have clearly had an edge in their interest-earning businesses over their peers in terms of growth, margins, and relationship to bond yields. Now, noninterest growth and margins will be analyzed.
Noninterest Revenue Growth
Determining the bank with the highest growth in noninterest revenues based on historical growth trends is much more difficult. To get a more quantitative ranking, I took a weighted average of the growth rates, giving growth in 2011 a multiplier of 1, growth in 2012 a multiplier of 1.5, and growth in 2013 a multiplier of 2. This showed C and GS with the highest weighted growth rate. However, these figures have been extremely volatile, making investments in C and GS inherently riskier.
Noninterest revenues over noninterest expenses were used as a proxy for gross margins. GS has been able to maintain a strong and increasing gross margin over its peers. Also notable is MS, the only other bank to attain a revenues over expense ratio of over 1.
USB and WFC have historically dominated the interest-earning sectors, while GS has their competitive advantage in noninterest-earning divisions. Given the different banks' exposures to the different income-generating activities, the ratio of interest and noninterest revenues should also be compared.
Interest over noninterest revenues
Both USB and WFC generate the majority of their incomes in their interest-earning divisions-areas where they have competitive advantages. C also generates far more revenue in their interest-earning division. However, it is not positioned as well as USB and WFC to take advantage of rising bond yields. GS, which has strong noninterest revenue growth and margin trends, is also continuously moving towards specializing in their competitive advantage.
2. Discounted EBT Analysis
Below are analysts' earnings growth expectations for these banks, found on the NASDAQ website.
Net incomes were then extrapolated, and the present values of these were compared to the market capitalization of the banks. The discount value was then found.
PV of Net income
Using these calculations, the market is discounting WFC and JPM the most. This implies that, if the NASDAQ analysts' predictions are correct, WFC and JPM stocks are the most undervalued.
3. Price to earnings
Similarly, stock prices will be ranked by their price over earnings before taxes ratios to determine which bank has the best value. There are two things to note here. Price over earnings before taxes is a much more stable ratio than the conventional price over earnings because of volatile tax expenses/benefits for bank stocks. However, this omits penalties and fines imposed by regulators.
Using this method, GS and WFC are the cheapest stocks. Normally, this means the market expects lower growth rates for GS and WFC. This is an anomaly, given GS' competitive advantage in their noninterest-earning business and WFC's strength in their interest-earning division. Consequently, investors are able to buy these stocks at a discount.
4. Return on Assets
Return on assets is also an important indicator for the banks. It shows how effective the bank can use its assets to generate income. In this case, I used EBT as the numerator. Both USB and WFC have exhibited the highest ROA, and have also been able to grow their ROA substantially since 2010. This reflects those banks' strong management versus their peers.
5. Return on Equity versus Price over Tangible Book Value
A similar metric, return (EBT) on equity, is also assessed. The downside is that the ROE at each bank is difficult to compare due to varying leverage ratios. However, ROE can be used in conjunction to the price over tangible book value ratio to determine which bank is relatively more expensive/cheap. Equity and book value are more easily comparable since they both omit liabilities. All things equal, a higher return on equity should cause the price over book value ratio to be higher.
Three stocks are trading under the trend line. That is, those banks are relatively cheaper, given their ROE and book values. C, GS, and WFC are cheaper compared to its peers using this methodology.
6. Allowance for loan and lease losses and net charge-offs
Given the expected rise in interest rates, and consequently interest income, banks' abilities to control their lending risk will have a significant and growing material effect on their earnings.
Allowance for loan and lease losses as a percentage of average loans/leases outstanding
WFC and USB have the lowest percentage of allowance for loan and lease losses as a percentage of loans and leases outstanding. This figure has also been shrinking year-over-year for all banks, which demonstrates the overall strengthening of the economy, and managements' ability to find less-risky borrowers. These figures complement the next analysis on net charge-offs/write-offs.
Net Charge-offs / Write-offs as a percentage of average loans/leases outstanding
Similarly, both WFC and USB have the lowest percentage of net charge-offs/write-offs. Managements' ability to reduce these added costs on interest-revenues have aided WFC and USB's competitive advantage in their interest-earning businesses.
7. Returning Value to Shareholders
One method of valuation for bank stocks is typically the dividend discount model. Growing dividends are a sign of bank stability, and investors searching for yield, growth, and value, will tend to flock to these stocks. A strong history of dividend growth demonstrates managements' friendliness to shareholders, and this attitude would likely continue in the future.
Dividend yield (%)
Due to current regulations, BAC, C, and MS have not adjusted their dividend payouts. On a positive note, if those regulations become less restrictive, those banks will have more freedom to increase their dividends, and the stock prices of BAC, C, and MS will likely increase. JPM, WFC, and USB have both increased their dividends significantly since 2010. 2013 was a slight anomaly-the large appreciations of financials caused the dividend yields to decrease. JPM was the only one of those banks to increase their dividend yield in 2013. Thus, JPM should be attractive for investors more focused on a high and growing dividend yield.
Diluted Shares outstanding
As shares outstanding falls, share prices should increase as earnings per share rise, and the supply of stock falls. Since 2010, only GS, JPM, and USB decreased their diluted shares outstanding. So, despite these large share repurchase programs, banks' issuance of stocks and stock payment-options in employee salaries often exceed the buybacks.
JPM and USB have historically been the most shareholder-friendly, given their dividend growth and share buybacks.
Below is a summary for my ranking for these bank stocks.
WFC is seen to have a strong advantage in their interest-earning division, loan risk management, and return on assets. Moreover, the stock is trading at a discount to its peers with respect to discounted EBT, P/EBT, and ROE versus P/BV. Although WFC has not returned value to shareholders as well as JPM or USB, WFC is still consistently growing its dividend, and has kept its diluted shares outstanding figure relatively flat.
Unfortunately, WFC still has a large exposure to regulatory risks. Firstly, settlements related to the mortgage crisis may still be ongoing, although WFC recently reached a $591 million agreement with Fannie Mae. Secondly, "banks could face tougher stress tests next year." Although this is a systemic risk for the bank stocks, WFC may suffer greater than its peers due to its relatively lower Tier 1 Capital levels. However, its Tier 1 Leverage ratio is stronger. Despite those risks, it seems WFC is the best positioned to take advantage of rising interest rates, and its stock price has yet to reflect this.