U.S. banking stocks can't catch a break right now. The mega cap U.S. bank stocks such as JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and Citigroup (NYSE:C) have been aggressively sold off since the beginning of the year.
The market appears to be taking the view that banks are going to be crawling along at a pedestrian pace for the foreseeable future. For dividend investors, there are still reasons to be optimistic about several of the large U.S. banks as a source of future dividends, however investors need to also understand that U.S. banks operate in a new economic framework.
To my mind, Wells Fargo and JPMorgan remain solid candidates for dividend investors to consider amongst large U.S. money center banks. While both banks have stellar management teams and strong reputations for risk management, I believe that Wells Fargo remains the better U.S. banking play, just shading JPMorgan.
There are several reasons to be optimistic on the large U.S. banks and JPMorgan and Wells Fargo in particular.
1) Rate repricing will eventually arrive
The U.S. banks have been stuck in their efforts to bring a measure of pricing power into their business. U.S. Federal Reserve Rates have remained at stubbornly low levels for the longest time. That's been problematic because the ability of larger lenders to price lending instruments higher and earn a spread over deposit rates has been diminished.
The U.S. Federal Reserve seemed destined to embark on an aggressive program of 4 rate hikes in 2016, however recent market turmoil seems to have put some measure of pause to this. At some point though, this cycle will turn, particularly given the strong data that has been emerging with respect to U.S. job creation and new housing starts. If international volatility settles down, then U.S. rate tightening will follow.
2) U.S. Bank deposit funding is much higher than GFC levels
U.S. banks as a whole are funding a much higher percentage of liabilities from core retail deposits as opposed to loans from wholesale markets. More than 50% of liabilities in U.S. banks are now funded from deposits, significantly up from just 37% prior to the GFC. That will be the earnings accelerator to be applied once interest rate increases arrive. Rate increases have a way of being applied very quickly to loan assets, and being passed on more much slowly to retail deposit bases.
That should result in real earnings acceleration as soon as rates rise. The greater the retail deposit base, the greater the potential earnings acceleration. Wells Fargo has a real advantage here over almost any other major U.S. bank. The company has almost 78% of its funding coming from retail deposits. That's a figure that is substantially more than other rivals, including JPMorgan which has approximately 53% of funding from retail deposits.
3) Wells Fargo and JPMorgan are now far more cost efficient
Both Wells Fargo and JPMorgan are far leaner, more cost efficient operations than prior to the financial crisis of 2008. Both banks have been on an austerity drive over the last few years and have achieved operating efficiencies with efforts ranging from real estate consolidation, process simplification and corporate reorganization.
JPMorgan's operating margins that are just shy of levels enjoyed in 2008 at 31.3%. However Wells Fargo has gone one step better. The bank has actually surpassed its operating margin achieved during its best days before the financial crisis. Wells operating margins took a significant hit post the GFC and plunged to 7.8% in 2008, from almost 35% in 2006.
It has been a fairly steady ride back, but Wells Fargo operating margins now exceed the levels that it hit in 2006, and are back to almost 40%. That's amazing when one considers that this has been achieved in an environment of negligible pricing power from a low interest rate regime.
JPMorgan and Wells Fargo now have remarkable operating leverage in their business models. Repricing of financial assets when interest rates go higher will not be an activity that adds significant incremental costs, and should largely flow straight to the bottom line.
So it can be seen that there are a number of positive things that are going for the large U.S. banks. However it's not all positive though. There are a couple of large headwinds that will be difficult to overcome.
1) Higher Capital Levels will mean lower returns on equity
Undeniably, large money center banks having to hold greater capital against their assets has resulted in returns on equity that are significantly lower than that achieved pre GFC.
Bank leverage ratios are markedly down on pre GFC levels, and investor returns on equity are trailing the levels seen pre recession. Both JPMorgan and Wells Fargo haven't performed too badly, however the advantage here is still to Wells Fargo. Wells is earning rates of return on equity of 13% in recent years, well below the 19-20% rates of return on equity that it enjoyed pre GFC. Similarly, JPMorgan is barely scratching 10% return on equity, down from the 13% or so it enjoyed pre GFC.
Lower returns on equity are problematic, given it means potentially lower earnings flowing through to investors from the deployment of new capital. However the returns that are currently being generated in the core banking business still remain at acceptable levels to provide steady earnings growth.
2) The elimination of Prop Trading has diminished earnings
The passage of the Volker rule has meant that banks can't make proprietary bets with their own capital. This requirement has permanently diminished the earnings capabilities of most of the big U.S. banks. Both Wells Fargo and JPMorgan made billions from using their own capital to take speculative positions on a variety of futures and commodities.
JPMorgan has been far more impacted by the passage of Volker than Wells Fargo, given it earned an estimated 15% of industry trading revenues before the crisis, versus Well's Fargo's much more modest 4%. In dollar terms that represented $10B in trading revenues to JPMorgan, versus just $2.5B to Wells Fargo in 2009. That's a significant amount of earnings that JPMorgan will struggle to recapture from other businesses.
Both JPM and WFC trade at the lowest valuation levels since 2012, with Wells offering a PE of just 11.6, and JPM offering a PE ratio under 10. Yields are also impressive, with JPM and WFC offering yields of close to 3%. Yield and valuation measures are significantly better than 5 years averages for both businesses.
With the U.S. economy showing evidence of consumer driven growth from falling unemployment and increasing housing starts, consumer lending should soon display strong signs of growth over the next few years. Add to the mix the eventual arrival of increased U.S. interest rates, then increases in earnings growth and dividends for several of the large U.S. money center banks should follow.
While both JPMorgan and Wells Fargo will benefit from these trends, I prefer Wells Fargo for the reasons outlined above. It for this reason that I'm determined to continue my quarterly investment in Wells Fargo as one of my 30 dividend stocks for 30 years. Analysts expect JPMorgan and Wells to increase earnings between 7-8% each over the next 5 years. That will make for some good dividend growth for investors in these companies.
With JPMorgan and Wells Fargo hovering well below recent highs now appears like a good time to buy for dividend investors looking for solid yield and income growth.
Disclosure: I am/we are long WFC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.