For a long time, I have felt that the big banks in the United States are drastically undervalued. Many of the stocks trade below tangible book value while historically banks have traded at over 2 times book. In my opinion, there are two reasons the large-cap bank stocks have been so weak. First is the lack of stock buybacks, and second is the failure in the administration of the banks' stock buyback programs.
Oversupply of Bank Stock
The world is awash in bank stocks. The global financial crisis forced the large global banks to issue unprecedented amounts of new stock. Now, with the European financial crisis, another huge wave of bank stock offerings is on the horizon. When it is all said and done, in the decade following the global financial crisis, investors will probably have had to absorb over $500 billion in new bank stock. This is an enormous amount of stock, and has led to today's supply glut. Making this situation worse, much of this stock has been/will be issued at prices that are dilutive to book value. Many investors have put off investing in bank stocks as they know that they will be able to buy into oncoming bank offerings at a significant discount to book value. This has dragged the whole sector down to valuations that are far from the historical mean.
All Banks, and Their Buybacks, are not Created Equal
Wells Fargo (WFC) - Wells is now the darling of the large-cap US banks. It trades at 1.4 times tangible book and sports a 2.8% dividend yield. The company also has a moderate stock buyback program in place. If the other large cap banks stocks gravitate towards the valuation of WFC, the banks' share prices have significant upside.
J. P. Morgan (JPM) - After its humiliating trading loss, the stock is now trading close to tangible book value. The bank sports a 3.6% dividend yield, and has suspended its massive $15 billion stock buyback program. Historically, the company has been buying back shares at average prices of around $40 per share. This pre-emptive buyback suspension (although disappointing to all bank stockholders) was probably the right decision.
If JPM had continued to buy back shares, the company would be at risk of the regulators forcing the suspension of the program. Hopefully, after the June quarter's earnings report, JPM will resume their buyback plan. In order to do this, management will have to have ring fenced potential losses from the infamous London whale's trading debacle. Once buybacks are resumed, the valuation of JPM should slowly gravitate towards the valuation of WFC.
Citigroup (C) - Like JPM, C also recently had a humiliating episode for management (the rejection of its $8bn buyback plan proposed in the recent stress tests). A few days ago, when C presented its amended capital plans to regulators (required by the stress tests), the company informed the public that it will not be conducting any buybacks in 2012. This announcement was a significant disappointment, as it was a change of course from the previous guidance of management. Any buyback (large or small) would have been highly accretive to tangible book value because the stock trades at less than 60% of tangible book. As for the dividend, Citigroup's yield is too small to even be relevant. Unless bank valuations increase across the board, the stock looks like it will be going nowhere until buybacks begin.
Bank of America (BAC) - BAC, like Citigroup, has a tiny yield and no buyback. It also trades at less than 60% of tangible book value. It probably is the bank that has the most to benefit from a housing market that has bottomed. However, it will also probably trade in line with the sector until meaningful dividends and buybacks are put in place.
Goldman Sachs (GS) - This is the one bank I just don't understand. It has a huge buyback program, amounting to almost 20% of the shares outstanding. Its shares trade at less than 80% of tangible book value, and in recent history, the company was buying back significant amounts of stock at above tangible book value. Now that the stock is significantly below tangible book, the buybacks have slowed, amounting to just $362 million last quarter. This seems to be a very weak display of confidence by management. Making them look even weaker is the fact that GS is subject to a dilutive option, which Warren Buffett can exercise to buy $5 billion worth of the stock at 115 (tangible book is over 120). It is perplexing that management has not used the buyback program to offset the dilution they will likely suffer at the hands of Buffett, if he ends up exercising his option to buy at 115. It makes me seriously doubt the leadership of GS is properly aligned with shareholders.
Morgan Stanley (MS) - This stock has a 1.5% yield, no buyback program, and trades at close to 50% of tangible book. In the next few months it is highly likely that MS will spend up to $3bn, to purchase an additional 14% of their brokerage joint venture with Citigroup (at a valuation close to book value). $3bn is over 10% of the market cap of MS. My view is that this money would be much better spent on a highly accretive stock buyback. Management is trying to buy an asset at close to book value (brokerage JV with Citigroup), when they can buy back their own shares at half the valuation. It makes absolutely no sense to me.
Buffets Buyback - A Textbook Case on How to Execute a Buyback Program
I still am perplexed that CEOs have not taken a cue from Warren Buffett, the greatest investor in modern times. In Berkshire Hathaway's (BRK.A) buyback program, there is a price limit for which buy orders in the program will be executed. This limit is 10% above book value. This has created a rock solid floor under Berkshire stock, while the chart of almost every other financial stock looks like a roller coaster.
Stock price stability is very important for a financial stock. When the prices of financial stocks swing up and down, investors lose confidence. If the banks had run their buybacks like Buffett, bank stocks would have rebuilt a lot of the credibility that they lost in the global financial crisis. Do these CEOs think they have a better methodology of allocating capital than Buffett? If so, they have lost touch with reality.