Dividend Reservoir: Reconsidering Bank Stocks

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Includes: BAC, C, COF, IYF, JPM, KBE, PNC, USB, VFH, WFC
by: Thomas Smicklas

Are you a dividend investor? For many of us the answer is yes. Most of the articles within Seeking Alpha pertaining to dividend-oriented investing have a tendency to look backwards, projecting an income stream through the assumption of what happened in the past to a company's fortunes (and the ability to pay dividends) will continue to occur. Most of us don't have a problem with that concept, especially if one's income portfolio is well diversified.

Jane Kim, in Banking on Bank Dividends in yesterday's Wall Street Journal, presents a well crafted article suggesting that dividend seekers should also look forward and seriously consider within a dividend portfolio securities that are apt to resume or significantly increase their quarterly payout. She focuses upon bank stocks.

Banks, out of federal coercion or corporate necessity, cut or suspended dividends due to the financial crisis. It appears that many of these institutions are chomping at the bit to resume healthy dividend payments, contingent upon their receiving a passing grade on the Fed's stress test.

In the article, Gus Zinn of the Waddell and Reed Core Investment Fund states that the investor:

will see stronger companies come out with decent-sized dividends and articulate road maps to potentially doubling (dividends) over the next couple of years.

According to Zinn, his fund is building up positions in J.P. Morgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Capital One Financial Corp (NYSE:COF). The fund has increased its financial stock exposure by 50% from the summer of 2010. Another fund manager quoted, Dave Ellison of the FBR Large Cap Financial Investor Fund, likes banks because of their significant improvement in earnings, warranting a significant dividend increase. "We are on the cusp of seeing some dividend enhancements," says Ellison. Companies such as Bank of America (NYSE:BAC), J.P. Morgan (JPM), Citigroup (NYSE:C), PNC (NYSE:PNC) and U.S. Bancorp (NYSE:USB) each make up around 5% of his fund.

For those of us that prefer to mitigate risk through diversification, ETFs will, to a degree, participate in this dividend revival. Vanguard Financials ETF (NYSEARCA:VFH), and iShares Dow Jones U.S. Financial Sector (NYSEARCA:IYF) show promise. The best pure play ETF to focus on bank stocks may well be the SPDR KBW ETF (NYSEARCA:KBE) which tracks the nation's largest banks. Investors should also know that according to this WSJ article, the preferred stocks of banks are also being accumulated, which stands to reason since better earnings indicate the ability to pay those preferred dividends which in many instances are not secured. Perhaps the best total return may come from banks "on the margin of being strong" such as Bank of America (BAC). I admit to a personal bias for individual security selection towards banks most likely to resume or raise dividends. ETFs or mutual funds may paint with too broad a brush to gain benefit from selected banks electing to return a share of their increasing profits to investors.

Hurdles for this scenario? Dividend payout ratios by banks have traditionally been in the range of 35%-45%. Stock dilution, with 92% more financial common stock shares than in 2008, is one issue. Secondly, banks, which had been used to paying 35-45% of their after-tax net income pre-2008 out in dividends will be limited to 30% after-tax net income. More will almost surely trigger Fed scrutiny.

For dividend investors, the attractive total return derived from banks that increase dividends will likely add not only zest, but common sense to the dividend portfolio.