Top Market Cap U.S. Banks: A Long Term View on Value

Contrarian value investors following methods prescribed by David Dreman in his book "The New Contrarian Investment Strategy" (book review notes here) might be tempted today to take a closer look at some U.S. banks. Dreman doesn't believe in market timing but he does believe that market participants are prone to making systematic errors in judgment due to inherent biases present in human behaviour. Essentially, when times are bad for the market, a sector or individual stocks, market participants have the tendency to be overly pessimistic and price in a perpetually bad scenario. Buying good quality companies with lower than average P/E ratios and higher than average dividend yields form the core of Dreman's contrarian strategy.

One problem with investing in the best banks is that it's extremely hard to know which ones they are! Managers of banks haven't been able to clearly identify all of the exposures and risks, so it's unlikely as individual investors that we will fare much better. In these type of circumstances, where superior knowledge of a company is not possible, it's better to spread risks out by buying a basket of sector stocks either individually or through a vehicle such as an ETF. This is a similar strategy as was advocated in the pharmaceutical article posted here.

Looking at three top market cap US banks, we observe the behavior of dividend yields over time. The long term average dividend yields for Wells Fargo (WFC), Bank of America (BAC) and U.S Bancorp (USB) across the entire time period of 1970 to 2007 is 4.07% (2007 data points are present on the graph but not labelled). The current 2008 average dividend yield for these three banks is 5.98%. One caveat to these higher than normal dividend yields is that the banks are at higher payout ratios than normal. However, all three banks have had higher payout ratios in the past so we are not in uncharted territory. (Click charts to enlarge.)

Below is a graph of P/E ratios for the same three banks over the 1970 to 2007 time period (WFC had a -ve P/E in 1987 but for graph legibility reasons this is not shown). It's interesting to observe the generally inverse relationship between P/E ratios and dividend yields. Around 1974 when inflation was rampant with sky high oil prices, the P/E ratios averaged 6.7 times and dividend yields were at 6.4%. During difficult banking conditions in the early '80s and in 1990, one observes a return to very low P/E ratios and high dividend yields similar to levels found in 1974.

Looking at current 2008 data, the combined average P/E ratio for these banks is ~15 times, which is still high by historic standards and yet the dividend yield is significantly higher than average. This data does not paint a consistent picture of value. If you believe in regression to the mean, then you would want to buy bank stocks when their P/E ratios are significantly under the long term average. The combined long term average P/E ratio for these three banks over the given time period is 12.7 times. When examined through the lens of P/E ratios, these three banks cannot be bought (yet) at historically cheap levels.

Comments

[Chemist29:]

Where were you on July 15th? I bought USB then, locked up a 7.8% yield and have gained 50% in stock appreciation. Buy on weakness. Only mistake, not buying more companies

2008 Sep 08 05:29 PM

[JasonC:]

Earnings of cyclical companies including banks need to be smoothed by using a 3, 5, or 7 year moving average for the denominator, to calculate PEs. Otherwise the PE only measures the volatility of the earnings themselves, and will be negatively, not positively, correlated with value.

As for which banks are the well run ones, there are two measures which are the best indicators of bank management quality. The first is the expenses figure - the leanest banks keep it down to 50% (USB is the only major that routinely posts numbers under that figure), and anything 60 or less is respectable. The second is an average return on assets over a full cycle. 1% is the requirement for a reasonably well run bank, while anything in the 1.5% range or higher is outstanding. You can expect a bank to average its leverage times that figure, plus a typical bond rate on its capital, long term.

All the well managed banks are exceptionally cheap right now. Consider foreign ones as well. While some of the European majors have typically had significantly higher expense ratios (and lower average ROAs because of it), the Barclay's and INGs are quite cheap right now, along with the 3 US banks the article mentions. JP Morgan should also be added to the list - it has navigated the present mess far better than most, and is in an excellent competitive position because of it.

2008 Sep 09 02:32 PM

[palsboss:]

I absolutely agree that financials will provide great long-term opportunities for investors. Problem with the advice given by all of the various websites, newspapers, magazines, etc., is that they never seem to talk about price. At current prices, I don't think there is value. First, many stocks are trading at prices similar to prices 3-5 years ago when the markets were great. Second, the market doesn't seem to be flush with value investors. Instead, it seems like a casino where you can make short pops on short-term positions. Stocks trade on any kind of rumor or news, whether relevant or not. So I would like to see some articles that recommend financials at specific price targets.

2008 Sep 10 08:12 AM