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With bank stocks getting hammered in particular this week, my ‘buy low, sell high’ instinct took over and I’ve been researching the twenty-year histories of my three favorite companies in the sector: Wells Fargo (NYSE:WFC), US Bancorp (NYSE:USB), and JP Morgan (NYSE:JPM). My general thesis about these companies is this — despite the gloom and doom forecasts about the financial sector due to the Dodd-Frank Bill, limits on fees, problems with loans, and the crisis in the Eurozone, these three companies are quietly racking substantial profits, and all three are paying out paltry dividends (in terms of payout ratio) that are well below historical norms and have ample room to grow.

1. US Bancorp (USB) — In 2007, US Bancorp paid out $1.63 in annual dividends relative to $2.43 in annual earnings, for a payout ratio of 67%. Right now, US Bancorp’s TTM earnings is $2.28 (yes, $.15 per share below pre-crisis levels), yet it only pays out $0.50 in annual dividends, for a payout ratio of 21.93%. Before even thinking about earnings growth, US Bancorp could raise its dividend to $1.14 annually if it wanted to pay out half its earnings in the form of dividends. Based on current market prices of $23.79, that would give current investors a hypothetical dividend yield of 4.79% on initial cost. US Bancorp is an interesting bank because the executives of the firm receive more in dividends from their shares than they do in annual compensation, which suggests that they ought to have an incentive to get US Bancorp’s dividend up close to pre-crisis levels. While there’s no guarantee that US Bancorp could pay out half its earnings in the form of dividends, the payout ratio of 21.93% does suggest continued room for significant dividend growth.

2. JP Morgan (JPM) — Although Wells Fargo (WFC) is Buffett’s big banking holding, I would not be surprised if he established a position in JP Morgan over the coming years. When Buffett interviewed with Bloomberg TV, he had this to say about Jamie Dimon, the CEO of JP Morgan, “Jamie Dimon is a fabulous banker, and probably writes the best annual report in America. I grab his report when it comes in and my friends do, too.” Right now, JP Morgan is trading at $28.38 per share, and pays out $1.00 in annual dividends based on $4.69 in TTM earnings for a payout ratio of 21.32%. If JP Morgan doubled its dividend to $2.00 annually, it would still only have a payout ratio of 42.64%, yet it would sport a 7.04% dividend yield relative to initial investment. Dimon has said repeatedly in his shareholder letter that he is committed to maximizing shareholder value due to a combination of share buybacks and dividend growth, and a combinations of earnings growth and an increase in the payout ratio (from the current 21% mark) seems to be a reasonable expectation for JP Morgan’s future.

3. Wells Fargo (WFC) — Charlie Munger and Warren Buffett have both lauded Wells Fargo’s ability to generate significant amounts of low-cost capital relative to peers, and the acquisition of Wachovia ought to add significant ballast to Wells Fargo earnings once the integration is complete and the economy shows moderate improvement. Currently trading at $23.38, Wells Fargo offers investors $0.48 in annual dividends relative to $2.70 in annual earnings, for a dividend yield of slightly above 2%. The current payout ratio for Wells Fargo is 17.77%. If Wells Fargo paid out 45% of its earnings as dividends, it would pay out $1.22 annually for a 4.51% dividend yield on initial cost. Buffett expects Wells Fargo to deliver ten percent plus raises in the dividend for the next five to ten years, giving investors the opportunity to enjoy a significant dividend yield relative to the cost of initial investment.

With trouble in Europe, weakness at home, and regulations looming over the banking sector, there is a pretty good chance that investors in any of these three companies will be in for a bumpy ride over the next medium to long term (5-10 years). I can’t guarantee that Wells Fargo, US Bancorp, and JP Morgan won’t fall to $15. I don’t pretend to know what stock prices will do. But I do know this — all three of these banks are making substantial profits in this environment (imagine what they’d be earning in a rebounding US economy) and they are paying out dividends that are only a third of the historical payout ratio for the banking sector (large-cap banking firms had an average dividend payout ratio of 63% from 1994-2007, and WFC, USB, and JPM are only paying out around 20%). Once these three banks start paying out substantial dividends that are in line with their earnings capabilities, the stock prices will most likely rise to reflect the floor that higher dividend yields have a tendency of putting on share prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: JPMorgan, US Bancorp, Wells Fargo: Unleash The Big Dividends