By James Brumley
In the week of March 12, the Federal Reserve gave the nation's major banks their third so-called "stress test" to determine whether they would survive another collapse of the financial system like the one suffered in 2008. Overall, the group passed the test, with 15 of the 19 undergoing the Fed's scrutiny being deemed capable of maintaining the needed capital levels to weather such a storm.
The Fed's positive opinion of those 15 banks, however, wasn't the aspect of the stress tests that prompted investors to begin an impressive buying spree. The bullish spark stemmed from what the passing grade meant those banks could do again, which is raise dividends.
The move pleased investors who've been waiting for the stocks to start paying better dividends. After all, the financial crisis notwithstanding, bank stocks have been some of the most reliably outperforming dividend stocks on the market. And the Fed's recent results could be just the signal investors have been waiting for to get back in and buy.
Pick of the litter
Which one of the 15 banks makes the most sense as a dividend play? The ideal bank would offer the combination of a strong balance sheet, debt that isn't facing a downgrade from Moody's or Standard and Poor's, strong profit margins and strong dividend coverage (that is, profits that significantly exceed the dividend payout). The Fed's stress tests looked at all of these factors, but didn't intensely focus on the latter three items, even though they are what reliably puts money in an investor's pocket.
To that end, the best-looking bank to rise to the top of the heap in light of last week's news is U.S. Bancorp (NYSE: USB), for a combination of reasons...
Technically it's a regional bank, but effectively, its $60 billion market cap and strong geographic market penetration puts it quietly on par with bigger brothers like Wells Fargo (NYSE: WFC) and Bank of America (NYSE: BAC). More important, it has the right stuff to maintain the quarterly dividend at its recently-raised rate of $0.195 per share. That dividend would translate into a yield of 2.5%.
While that's certainly not eye-popping at this point, you have to remember that the dividend has a very good chance of climbing significantly going forward.
Indeed, the bank has an impressive history of upping its payout as it grows earnings, cranking up its quarterly dividend of $0.17 in 2000 to $0.30 in 2005 to its peak payout of $0.43 per quarter in 2008, each of which mirrored increasingly stronger earnings. Earnings are on the rise again now, too, and have been since early 2010. And historically speaking, U.S. Bancorp has favored a dividend yield well above 3.5%, so the current payout of 2.5% may be a mere stepping stone to a greater payout.
As for other measures, U.S. Bancorp's balance sheet is admittedly just mediocre, at least according the Fed's stress test snapshot. The bank is sitting on $84.7 billion in cash and $283 billion in long-term investments. At the same time, it's got $261 billion in liabilities to manage. No matter how you slice it though, total assets exceed total liabilities by 11%, which is typical within the industry right now.
What the test doesn't adequately indicate, however, is how U.S. Bancorp avoided most of the 2008 financial debacle by not diving neck deep into subprime loans and shaky derivatives in the first place. That's why the bank was able to remain quite profitable in 2009 while other banks were dipping into the red ink, and why it's less likely than other banks to post big loan losses going forward.
The Minneapolis-based bank has also been disciplined about how much it pays out in dividends, too -- explicitly saying on more than one occasion it's aiming to pay out only about 30% of its income as dividends. The rate walks that fine line between being generous and being stifling. It's also the Fed's suggested maximum (though not mandated) payout.
There's no immediate threat of Moody's lowering the U.S. Bank's debt rating either, unlike J.P. Morgan (NYSE: JPM), Citigroup (NYSE: C), and Bank of America. Lower credit worthiness makes it more difficult for banks to borrow, crimping profitability.
Risks to Consider: While U.S. Bancorp is better positioned to control its own destiny more so than any other major bank, it's clear that external pressures from the Fed or a ratings agency like Moody's or S&P can still torpedo the dividend or the company's ability to pay it. Investors should keep tabs on any potential industry undertow as much as the stock itself.
None of this is to say other bank stocks aren't investment worthy, particularly to income investors. From a bigger-picture view, though, U.S. Bancorp appears to offer the optimal balance of risk, reward and sustainability.
Despite last week's 6.5% pop, shares are still valued at about 13 times trailing earnings, which is at the low end of the 10-year price-to-earnings ratio range of 5.5 and 30.8. Yet, earnings during the past four quarters of $2.46 per share are approaching 2006's record levels of $2.61 per share. If earnings grow as expected to $2.68 per share this year, then the stock could justifiably appreciate by as much as 20% within the next 12 months. At that point, the stock's price would only be around $38.40 and priced at a palatable P/E of only 14.3. It would also be paying out a nice dividend in the meantime.
Disclosure: James Brumley does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of WFC, C, in one or more if its “real money” portfolios.