Is It Time To Rotate Into U.S. Bank Stocks ?

| About: Wells Fargo (WFC)

Summary

The global financial sector has been under pressure for the last couple of years.

Global interest rates have been pushed down by central banks in an effort to juice their economies which has negatively impacted bank earnings.

Low commodity prices have hammered the balance sheets and income of oil, gas, and mining companies exposing banks to potential loan defaults.

Bank stock valuations have adjusted downward in response to lower for longer interest rates and commodity prices.

Introduction

The often used (and misused) quote "May you live in interesting times" I think is applicable to the stock and bond markets over the last couple of years. The quote, often attributed to Confucius, is neither of Chinese origin nor a blessing. It is more akin to a curse and dates back to about 1929 ( Quote Origin Link). I think the markets have been very chaotic and disordered over the last couple of years and we are likely to see more of the same in 2016. For me, this means we will probably have a stock picker's market for some time to come. I was not much of a fan of index investing to begin with and I believe the current market requires a much more careful and selective approach to investing.

With global economic growth slow, most countries' central banks have lowered interest rates, some into negative territory, and utilized other forms of monetary stimulus in attempting to juice their economic growth. This has not been good for bank profits. Banks make money on the margin between the money they borrow (deposits, bonds, preferred issues, etc.) and the money they lend to borrowers (mortgages, business loans, revolving credit). When interest rates are under downward pressure for so long, the margins get compressed and banks profits from loans come under pressure. I certainly never expected interest rates to be this low for this long. It is clear that the US Federal Open Market Committee (FOMC) has been conflicted over the last few months between standing pat on US short term rates or raising those rates. Eventually, the FOMC will begin normalizing short term rates in earnest.

Commodities and, in particular, crude oil and natural gas have crashed to inflation-adjusted prices not seen in a couple of decades.

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The commodities price crash has resulted in postponement or cancellation of future development and production projects around the globe. Mines have closed, oil and gas projects have been cancelled and global commodity production is beginning to drop. While it is difficult to predict when production (supply) and consumption (demand) will come into balance, it is clear to me that a balance will be achieved and it appears that the necessary rebalancing has started. As commodity prices firm up, so will the balance sheets of the companies in the business of producing and transporting those commodities for markets around the world. This will also bolster the balance sheets and income statements of the banks that make loans and provide banking services to the companies in the commodities business.

The stock market and stock valuations are highly anticipatory. In other words, if investors wait until the bank balance sheets and income statements reflect the improved commodity prices and/or a rising interest rate environment, the impact will already be reflected in bank valuation. Given the highly anticipatory nature of the market, it may be time to consider a rotation into bank stocks. I previously wrote about the Canadian banking sector in a couple of articles published on Seeking Alpha. Those articles can be found here and here. Today, I took a look at a handful of US based banks for possible investment.

US Banks

In my search for banks worthy of investment, I ended up with only four and really narrowed it down to just two after looking closely. I should be clear that I did not start with a complete list of US banks. Early on, I decided to limit my search to the larger banking institutions including some large regional banks. In consideration of full disclosure, I actually started out looking at both US-based and European banks but quickly dropped the European banks from further consideration due to the poor financials they currently offer. The European banks I looked into briefly were UBS Group AG (NYSE: UBS), Barclays PLC (NYSE: BCS), HSBC Holdings PLC (NYSE: HSBC), and Credit Suisse Group AG (NYSE: CS). Only BCS came close to making the cut but I'd still characterize BCS as the best of a sorry lot of European offerings.

The list of four US banks that did make the cut are Branch Banking and Trust (NYSE: BBT), JP Morgan Chase (NYSE: JPM), PNC Financial Services Group (NYSE: PNC), and Wells Fargo (NYSE: WFC). Below is a summary table of the metrics I compared for my initial screening.

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Source: Author

Analysts Ratings Key: Buy/Outperform/Hold/Underperform/Sell

BBT

BBT is a large regional bank with operations spanning the mid-Pennsylvania area through the southeast into Mississippi and skipping Louisiana into Texas. I use BBT for some of my personal banking and I have owned BBT as an investment in the recent past though I don't own any BBT shares directly at this time. The bank is growing quickly through both organic growth and by acquisition of other smaller regional banks. A thorough and complete analysis of a bank is complex and time consuming and I won't repeat all the metrics I look at here in this article. Rather, I urge the interested reader to spend a little time on the BBT website reviewing the latest financial reports and investor presentations. The link to BBT's latest investor presentation is here.

BBT's metrics in the table above are very respectable, with the highest 5 year earnings growth of 17% per year and very respectable dividend growth of 12.5% per year. Though still very much in the "safe" range, it has the highest dividend payout ratio at 41%. It should be noted that all of the 10 year dividend growth numbers suffer from the dividend cuts made during the 2009 financial crisis. BBT's dividend, despite the respectable growth, has not yet returned to its pre-crisis level.

One area that deserves some discussion is BBT's exposure to oil and gas ((O&G)) industry loans, as this is one of the drivers for the banking sector's swoon in the last few months and is currently a media hot topic. BBT has relatively light exposure to O&G loans with approximately 1% of BBT's loans going to O&G related businesses. As you will see later, this is the lowest exposure of any in this group of four. BBT has set aside reserves equating to 5% of their total O&G loan book. With only 1% of loans concentrated in the O&G sector and having set aside 5% of that in reserves, I would not expect BBT's earnings or financial health to be adversely impacted by defaults in the O&G industry.

JPM

JPM is one of the too-big-to-fail ((TBTF) banks in the US and in reviewing the latest investor presentation I was certainly convinced that JPM deserves the TBTF label. JPM appears to be in every aspect of banking and doing well at growing its business beyond TBTF. There is enough material available in just the most recent investor presentation to keep a potential investor busy with due diligence for a full day. The interested reader is directed here to get the full overview of JPM and its financial performance of late. From the metrics in the table above, JPM has the lowest price to book and PE of the group, along with very respectable earnings growth and dividend growth.

There are a couple of areas on which I will provide some additional detail. JPM has a very solid balance sheet and made significant headway in strengthening that balance sheet in 2015 compared to 2014. JPM has some exposure to the O&G industry with about 1.6% of existing loan book concentrated in that industry. Approximately 39% of that 1.6% are loans to exploration and production ((E&P)) companies and the majority of those E&P loans are to US firms. JPM currently has about 4% of the O&G loan values set aside in reserves and has plans to add to those reserves in the coming quarters. With relatively low exposure and significant reserves set aside, JPM should escape significant impacts to its earnings short of widespread O&G company defaults in the US.

PNC

PNC is another large regional bank with headquarters in Pittsburgh and retail banking operations in most states in the eastern half of the US. I formerly owned PNC when it was known as Pittsburgh National Corporation and when it was much smaller. Having owned it for several years, I finally sold the shares after more than an 8x increase in the stock price and several years worth of dividends. Today, PNC is a different bank, much larger and much less nimble than it was when I owned it 20+ years ago. Today, PNC carries a low price to book value but its earnings and dividend growth is the lowest of the four banks. For those wanting more detail on PNC financials and operations, its investor website can be found here.

PNC also has a relatively low exposure to O&G industry loans, (1.3%) but also the lowest in reserves set aside to cover potential defaults within that industry at 1.3% of its O&G loan book. While I always take analysts' ratings with a grain a salt, PNC has the poorest set of ratings in the group.

WFC

WFC is another TBTF bank with over 70 million customers and operations across the US. Like JPM, WFC covers all aspects of commercial banking and is working to continue to grow its banking footprint. It is interesting to note that both WFC and JPM compare their performance metrics to each other. They do, of course, draw slightly different conclusions from the comparison. In the table above, we can see that WFC has the highest book value and the highest 5 year dividend growth of the four. Like JPM, the WFC investors' webpage has a wealth of information available for those interested in more detail.

One area of concern relative to the other three banks is that WFC has the highest percentage of its loans with O&G companies at 1.9%, with about 45% of that concentrated in E&P company loans. While this does raise some concern, WFC has put aside reserves totaling 7.1% of its O&G loans to cover potential losses. WFC's reserves should go a long way towards satisfying skeptical investors that they can withstand the potential losses without significant impact on earnings in 2016 and 2017.

Conclusions

Given the summary metrics laid out in the table above, pouring over numerous articles on US banks, and three days studying the investor information on the respective banks' webpages, I'm leaning towards investment in WFC and possibly JPM. I will likely wait until earnings are reported this coming week to see if there are any surprises either good or bad. JPM reports its first quarter 2016 results on Wednesday morning before the market opens and WFC reports its results on Thursday morning. I should also make the comment that I'm not expecting immediate results from investments in either of these companies.

Our low interest rate regime in the US will likely be with us for the remainder of 2016 (it is an election year after all) and it may take several more months before commodity prices really begin to firm up. Either or both of these stocks are intended to be long term dividend growth investments for me and will likely also be added to my sister-in-law's stock portfolio which can be found here.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WFC AND JPM over the next 72 hours.

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.