Big Reasons To Be Back In Banks

by: Efficient Alpha

By Joseph Hogue, CFA

Two primary risks are keeping U.S. financials down, and have been for the better part of the last six months. Fortunately, uncertainties over banking reform and the European debt crisis have a finite life span and can be hedged. The short-term environment over the first half of the year may still see some weakness but the latter half of the year promises to see upside potential.

Death by Dodd-Frank

Dodd-Frank has been held up by many financials bears as a death knell for the sector. While the regulatory reform imposes some hefty costs and significant change, banks will find a way to make money in any regulatory environment. The real headwind created by Dodd-Frank is the uncertainty created by the political tug-o-war in Washington. Bloomberg reports that delays are making it harder for financial firms to plan, especially given the delay in assigning criteria for the designation of systemically important firms.

Though the most damaging regulations do not take effect for some time, many in 2013, the daily uncertainty over which parts of the bill may be adjusted is keeping investors out of the shares. Time, and the actual implementation of some provisions, will naturally remove much of the uncertainty but the development of this year's election cycle may boost bank shares as well.

Republicans currently hold a majority in the House and a slim disadvantage in the Senate. Recent polls put President Obama at a slight advantage over a possible contest with Mitt Romney. Though the economy, and more importantly employment, has picked up momentum lately it will still be the number one issue coming into November, and as the Republicans pick their eventual nominee there is a good chance that support will increase for the party and the presidential polls will fluctuate. Unless the economy improves significantly during that time, the market may start pricing in a republican victory not only in Congress but also in the White House.

This kind of an outcome in November, or even the shift in sentiment beforehand, could be a supporting factor for financials as a republican administration would more likely repeal some banking reform.

European Debt Disclosures

The crisis across the Atlantic has been covered ad nauseam and I won't go into too much detail here. A prior article looks at the specific causes and how investors can position their portfolio against further weakness. Frankly, Europe has three options out of this mess: growth, default, or print their way out of it. Forecasted economic growth around the flat-line this year and little better in 2013 does not make the case for growing out of debt problems. A default by one of the larger, systemically important countries like Spain or Italy would probably be the least palatable outcome. As of yet, the ECB has been adamantly opposed to massive lending and stimulus but this may be the only realistic solution over the next few years.

A particular short-term risk to Europe comes in the massive amount of bank debt that must be issued during the first half of 2012. The region had relatively little problems issuing enough debt to cover maturities in 2010, with a net deficit of only EUR 3 billion. The deficit last year increased to EUR 110 billion which had to be financed by the ECB. The region will have EUR 802 billion in maturing debt this year, with over 300 billion of it in the first quarter. While U.S. financials do not appear to have a large stake in euro zone banks through assets or derivatives, any headline risk out of Europe is sure to send bank shares down. While Europe's risks from the crisis may extend further, the risks to U.S. financials seem to be predominantly focused on the next six-months.

JP Morgan Chase JPM reports its quarterly results on Friday and will most likely show a six percent increase in earnings for 2011. Revenue at the firm's investment banking unit continues to slide while profits from trading may be relatively flat from last quarter. Despite continuing weakness in the sector, JP Morgan is generally considered one of the healthier, big banks. It may not be performing as well as some of the smaller regional banks but neither does it have the problems of many peers.

Bank of America BAC is the favorite stock to hate among investors in the banking space. The second largest bank by assets will post adjusted earnings of around $5.8 billion for last year, a decline of about 63% from 2010. Given the perennial pessimism and a long-term positive outlook on the sector, it may soon be time to start adding BAC to banking positions. At a 55.8% discount to its 52-week high, there is certainly upside potential relative to peers. With a market cap of almost $70 billion, the bank is systemically important to the economy and the likelihood of total wipeout is small. The stock may not be a large holding within an investor's financials portfolio but possible turnaround surprises make it one to consider.

Wells Fargo WFC has effectively closed the revenue gap with some of its peers by focusing on consumers rather than investment banking and structured products. Valuations are higher than most others in the space, but still not outside of reason. The bank's shares have fallen 7.5% over the last twelve months, relatively little compared to the 18% fall for JP Morgan and the 54% plummet for Bank of America. The company will report earnings on Tuesday.

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The number of bank mergers and acquisitions has been declining since 2007 and is at multi-decade lows. A report by Deloitte showed that the average price by tangible book value decreased to 107.5% in November of 2011, the lowest since at least 1990. European banks are aggressively divesting foreign assets in order to meet new liquidity and capital requirements. This could lead to increased deals as these assets are picked up by domestic firms. Large banks may continue to seek economies of scale as smaller banks decide to be acquired rather than cope with additional and more costly regulatory burdens.

Within the U.S. market this means smaller regional banks with strong balance sheets and good profitability could be targets for larger banks.

Huntington Bancshares HBAN provides commercial and consumer services to customers in Ohio, Michigan, Pennsylvannia, Indiana, West Virginia, and Kentucky. The company operates a system of approximately 600 traditional and convenience branches with 1,300 ATM sites. While the housing crisis has not hit much of the bank's market as severely as in other states, serious economic challenges have hit Michigan and Ohio over the last decade. Despite this, the bank has performed well with an operating margin well above other regional banks and still sells for a reasonable valuation.

Valley National Bancorp VLY provides banking services to customers in New Jersey and New York. The company operates 197 full-service banking offices. The bank's market is more limited in scope compared to many other regional banks, but it is hard to argue with its profitability. Return on equity and operating margin are both strong and the dividend yield is one of the highest among peers. Valuation is a little high but reasonable considering fundamentals.

Outside the U.S. market, emerging market banks have the opportunity to increase their own share of the market. The emerging world has done much better over the last few years and banks in the region are in a stronger position to add growth through acquisitions. As the European banks sell off assets to meet capital requirements, these assets could be targets for some of the larger domestic banks.

Itau Unibanco ITUB provides primarily commercial and corporate banking services but also some retail services within the financial sector. Clients tend to be small to middle-market companies in Brazil and internationally. The company has a network of 3,747 full-service branches, 913 customer service sites, and 28,844 ATMs in Brazil. The bank is clearly the powerhouse in the fast-growing Latin American market and should benefit from regional growth and relatively low loan penetration.

ICICI Bank IBN provides banking and financial services throughout India and around the world. The company has a network of approximately 2,529 branches and 6,104 ATMs, primarily in the emerging world. The bank's dividend yield is not as attractive as others in the space but valuations are lower as well. The bank should benefit as the Indian government further opens up the country to foreign investment and ownership.

A Risk Reduced Play on the Theme

Risks to financials, particularly economic and headline risks, appear to be more focused on the short-term while valuations paint a better long-term picture. This makes covered calls a good strategy to limit downside risk in the short-term. This strategy involves buying the shares as one would normally do while selling call options against the position. The investor collects a premium for the options which can be used to limit losses should the stock price decrease. If the shares increase over the exercise price by the expiration date, the stock is sold for the agreed price. This may limit the amount of upside gain, but that is the price you pay for limiting your risk. Given short-term uncertainties, investors may choose to sell call options expiring mid-year.

This strategy can be used with the individual names profiled above or can be used with a sector fund as well. The SPDR Select Sector Financials XLF provides broad exposure to the financial services companies in the S&P500. The advantage of the fund is that it removes much of the company specific risk but still provides exposure to the upside potential in the sector from its low relative valuation. The June $14 call options on the XLF are selling for around $0.92 per share. Selling these options effectively lowers the cost basis for the shares from $13.86 to $12.94, a discount of 6.6%. If the shares rally over the next five months, the investor will sell their shares and take a maximum return of 8.2%. If short-term risks keep the shares under the $14 strike price, the investor keeps the shares and the premium. This strategy can be repeated and is often used to produce income from a stock portfolio. The investor simply adjusts the strike price of the sold calls according to risks and a target price.

While the article has focused primarily on shares of financial companies, previous articles have shown ways to hedge short-term market risks in a general portfolio. Outside of financials, the prevalent risk on the market is from an escalation of the European debt crisis. Economic fundamentals in the United States are picking up and the emerging market is still relatively strong.

Fortunately, as shown in an article a few weeks ago, there are ways to separate the risk of further European problems from your portfolio. I have been using another strategy to limit the European banking risk in my U.S. financials portfolio since late last year, as described in an article detailing the strategy.

Disclosure: I am long XLF.