Which Banks?

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Includes: BAC, C, JPM, TRV, USB, WASH, WFC
by: Jim Sloan

Summary

I recently suggested gradually easing out of REITs in favor of banks in retirement accounts: but which banks?

Three main options include banks such as regionals which serve as bond proxies, stalwarts with some growth such as JP Morgan and Wells Fargo, and damaged banks on the mend.

Damaged banks like Citigroup and Bank of America, which have recently received permission to return capital as dividends and for buybacks, are interesting because selling below tangible book.

A little arithmetic suggests that total return prospects may be quite good because of retiring shares at prices under book even if there is no overall growth.

Readers should carefully consider personal goals and risk tolerance in choosing among these possibilities, in this as in all investments.

In my most recent article I suggested easing IRA money out of the most loved area of the market, which I believe is REITs, and gradually shifting it into the area I consider the most hated. The currently most hated area, in my opinion, is the banks. I think income investors could grit their teeth and buy them. But which banks?

Of the many comments, a large percentage raised that question. The suggestions ranged from particular major banks to regionals and even to foreign banks (which I must say I don't much like; one of the virtues afforded by many U.S. financials is that they remain firmly grounded in the U.S.). In this follow-up article I will address the comments by suggesting a threefold approach.

I think there are basically three ways to come at investing in a bank: (1) choose a bank which serves essentially as proxy for a bond, (2) choose one of the stalwarts for combined income, growth, and safety or (3) choose one of the recently troubled banks now on the mend and selling at a price relative to book value which enables some effective financial engineering. Which approach one chooses has to do with one's purpose and risk tolerance. Here are my candidates in each category, and the reasoning behind them.

1. Bank As Bond

It is important to remember that no stock is ever quite a true proxy for a bond, bonds having a position in the capital structure which makes them much more secure in hard times. No stock is a substitute for that. MLPs certainly weren't. Utilities aren't. Consumer staples companies aren't. REITs aren't. And banks certainly aren't.

That being said, local and regional banks can come pretty close. Local and regional banking are the banking of my grandfather (who was president and CEO of one) and my father (who paid off his mortgage and ceremoniously burned the note in our outdoor barbecue pit). The model is simple and understandable. The bank takes in money from the community and then lends it out again, earning money on the difference between its borrowing and lending rates and providing a valuable service to people they generally know well.

I have no profound investment knowledge of local/regional banks, but fortunately a couple of SA writers I respect, Ian Bezek (the article now behind the Pro wall) and Caiman Valores in this article have written on one of them, Washington Mutual (NASDAQ:WASH). I read their articles with interest and followed up with some study of my own.

WASH is fully priced at a little over 15 times earnings, and its growth prospects are not great in the immediate future, but its portfolio is low risk, having no oil and gas exposure on the one hand and large local healthcare exposure on the other. It has a dividend yield around 3.75%. As far as one can gauge these things at a distance, it appears pretty safe. I think of it as an almost bond, with the above caveat, and may purchase it in moderate size as I ease out of REITs in my IRA.

2. Buy The Best: The Stalwarts

There are really just two, and they need no introduction nor much analysis, especially on Seeking Alpha. I know both of them well and own a large position in one, Wells Fargo (NYSE:WFC). The other is J.P. Morgan (NYSE:JPM). I also own a modest position in U.S. Bank (NYSE:USB), but find it a little pricey at the moment. These are your choices if your operating principle is to own the best blue chip. Here is the comparison:

1- Wells Fargo. Long term, WFC has earned the best reputation among large banks. It's the most purely domestic, because its strongest element, control of about a third of the mortgage market, is domestic. Its investment banking area is small. WFC is a plain vanilla bank on a national scale. It famously cross-sells products to its customers. The one caveat on Wells Fargo involves recent criticisms of its quality of earnings and some of its lending practices. These are well documented on SA.

2- J.P. Morgan. JPM had a bit more trouble in 2009 and has a large investment banking side, significant international exposure, and less traditionally predictable profits. CEO Jamie Dimon, however, is probably the best current bank CEO. He's worth following for his informed opinions on many subjects and he has recently cautioned that Brexit may lead in a few years to the breakup of the Eurozone with consequences for JPM's European business. He seems confident, though, that JPM will solve those challenges.

A restoration of Glass-Steagall separating retail banking from merchant banking and trading would obviously impact JPM more than WFC. Although both political parties call for it in their platforms, it seems pretty unlikely. The counterargument would be the same argument used by the Clinton administration of the 1990s, that such separation greatly diminishes the U.S. role in international finance.

In the stagflationary era of the 1970s and early 1980s, when sharply rising short rates threatened banks by reducing net interest margin much as the flat yield curve does today, a friend and I used to argue which banks an optimist should buy - buy the best or buy the worst? The best were more likely to muddle through reasonably. The worst had more leverage for a gangbuster return if things worked out.

Here's my option three: buying the worst. That, by the way, seems to be an unstated premise of this recent pro-bank piece by Oppenheimer.

3. Buy The Worst: Let The Arithmetic Work For You

The worst are Bank of America (NYSE:BAC) and Citigroup (NYSE:C). By worst, I mean mired to the greatest degree in lingering problems from 2009 and treated by the market as cripples. They suffer from the most lingering hatred from everybody, including investors. For that reason alone they are interesting. Needless to say, they are the cheapest.

What makes BAC and C interesting is that they are both making money despite a terrible environment for banks, they have both gotten permission from the Fed to return substantial capital both as dividends and as stock buybacks, and they are both selling below tangible book value - BAC at .9 BV and C at .7 BV.

Let me tell you a story about arithmetic. I mean there is some analysis and some research, but the heart of it was arithmetic. In 1992 West Coast banks were in a similar situation as the California housing market collapsed. The most conservative bank in that market appeared to be BAC - then considered a stalwart. The dog at that time appeared to be Wells Fargo. That was the old Wells Fargo before the important merger with Norwest, which was the making of the modern Wells Fargo. Just the same, it was a pretty solid bank.

An account of the compelling arithmetic arguing in favor of buying Wells Fargo at that time is told on pages 220-228 of Magic Formula author Joel Greeblatt's wonderful book You Can Be a Stock Market Genius (which of course you can't and I can't, but he is). It's in a chapter about "stealing" the ideas of other geniuses, and the genius whose idea on WFC he copied was the young and then unknown Bruce Berkowitz, then a low-level analyst at Lehman, now a certified investing genius.

What Berkowitz noticed was that while WFC had about five times the real estate per share on its books compared to BAC, it was also very heavily reserved and had been writing off potential losses at an extremely heavy clip. The loans being written off were almost all actually still performing. WFC was selling at $77 per share - this was December 1992. Berkowitz's simple arithmetic showed that if WFC merely reduced its write-offs to a more normal $6 per share, normalized pretax earnings would be $30 per share, or $18 dollars after taxes. At a mere 9 or 10 times earnings, WFC shares were worth $160 to $180, and that was current earnings, with zero growth factored in. Greenblatt, being a genius himself, knew genius when he saw it, and added his personal wrinkle by buying not the stock but the LEAPs. Well, I'm not about to suggest long term call options, but I don't rule out doing it myself.

Leaving that 1992 situation, in which a little poking around and some simple arithmetic made big time returns, let's look at the BAC and C situations, focusing on Citigroup because of its greater discount to tangible book value. They are two of the most controversial stocks on SA, and some articles are so venomous that I can almost listen through the author's words and hear a snarl. When anything is that hated, I give it a second look.

I'll grant that many of the negative points have elements of truth, but I doubt that the Fed, having been so recently and badly burned, would allow the high level of dividend increase and overall capital return they have okayed if the intense scrutiny of stress tests had revealed fundamental problems. They made both Citi and BAC jump through major hoops, especially BAC.

But let's look at Citi, as it is selling at the deeper discount to tangible book. It has been allowed a dividend amounting to about a 1.5% yield, not much at first glance, but it has also received permission for share buybacks totaling 8.6 billion, which at the current price amounts to about 6.7% of market cap. Now let's do some arithmetic.

What happens if Citi executes this buyback at anything around the current market price? The basic thing is that it retires 6.7% of its shares. That means that its earnings per share increase 6.7% even if total earnings remain constant. It also means that book value per share increases at the same rate, so that if the price remains constant next year's discount to book value increases at a rate reflecting division by the smaller number of shares. Finally, it means that Citi can raise its dividend that same 6.7% per year while paying out the same number of dollars from its treasury as the previous year.

Not only that, the process can go on compounding investment value year after year without so much as a nickel's increase in earnings - a target I think these banks very likely to exceed. The only thing that would slow down the compounding afforded by large buybacks of a stock selling below book would be a rise in the stock price. This is not the worst thing that can happen to an investment, although two or three years languishing below book would be nice. It would be wash, rinse, repeat. Repetition for ten years would cut the share float in half and double the dividend - this without any increase in profits. It's simple arithmetic.

If this seems unlikely, it's worth having a look at the ten year history of Travelers (NYSE:TRV), which has done almost exactly that - cut the float in half over ten years enabling large annual increases in the dividend without an increase in aggregate cash out the door. A little upward float in PE, from about 9 to about 11, has made TRV a magnificent total return investment despite essentially zero growth. Citi's PE, take note, is about 9.5.

BAC will benefit from its .9 price to tangible book, although not to quite the same degree, but it pays a currently higher dividend (2%) and one might argue that it is earlier in the recovery process than Citi, only recently having emerged (largely) from a string of punitive settlements and gotten approval of capital distributions. So take your pick.

Conclusion

When I suggested banks as REIT replacements in IRAs, I mentioned that I started with adding to Wells Fargo. That's probably the conservative approach. Depending on your goals and risk tolerance, however, each of the three approaches might be worth considering. It's something like WASH if you want pure bond-like income. It's WFC or JPM if you want income and growth with stability. The Citigroup and Bank of America stories may strike you as a bit racy, for retirement accounts, although I suspect rising dividends accompanying buyback arithmetic to produce excellent return at somewhat higher risk. All three approaches, or a combination of the three, might also fill that bill. Just know your goals and your risk tolerance and as always do your own analysis and draw your own conclusions.

I currently own WFC and USB, but may buy any or all of the banks mentioned within a period of days or months.

Disclosure: I am/we are long WFC, USB, TRV.

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.