After The Stress Test, Are Financials Dividend Growth Stocks?

Includes: BAC, C, DFS, JPM, XLF, ZION
by: Charles Lewis Sizemore, CFA

29 out of 30 isn't too shabby. The Federal Reserve released the results for its latest stress test, and 29 out of America's largest 30 banks met their required capital requirements. Only Zions Bancorporation (NASDAQ:ZION) - a relatively small player - failed to make the cut.

Credit card issuer Discover Financial (NYSE:DFS) received a clean bill of health and responded much as its shareholders might have hoped - by raising its quarterly dividend by 4 cents to 24 cents per share.

It's been a rough couple of years for bank investors. After the 2008 meltdown, the government wanted to make sure that it would never be forced to bail out the financial sector again, or at least not on the scale we saw in 2008. As a result, banks have been forced to reduce leverage, maintain much higher levels of high-quality capital, and - as a means of conserving cash - refrain from making dividend payments or share buybacks.

So, with the Fed's stress test out of the way, can we expect to see wholesale dividend hikes across the financial sector? Maybe. We'll find out next week - the Fed has an announcement planned for March 26.

The Fed has been pretty good at playing its cards close to the vest. But based on the results of the stress test, we can handicap the odds that they will allow a dividend hike on a bank-by-bank basis. Let's use Bank of America (NYSE:BAC) as an example. The Fed found that BAC's Tier 1 leverage ratio would fall to as low as 4.6 percent under the "severely adverse" scenario, only slightly higher than the regulatory minimum of 4%. Still, with "excess" capital of about $13 billion, the consensus view is that BAC will raise its quarterly payout from one cent per share to ten cents. Under this scenario, BAC would yield about 2.3% at current prices.

Citigroup (NYSE:C), which, like BAC, currently pays out 1 cent per share quarterly, is expected to raise its dividend to about 5 cents. At current prices, that would give it a yield of about 0.40%. JPMorgan Chase's (NYSE:JPM) annual dividend is expected to rise from $1.52 per share to $1.67 per share, giving it a yield of about 2.8%.

If you're buying a stock with the specific goal of generating income, none of these potential yields are going to be particularly inspiring. Though, at least in the case of JPM, the expected yield is higher than what you can expect from the 10-year Treasury.

This brings me to what I consider the single most important issue for any investor in or near retirement. If you want to keep up with inflation - even the modest 1%-2% variety we have today - you need your income stream to rise over time. Even a seemingly innocuous 2% inflation rate represents a loss of purchasing power of 22% over the course of a decade.

Standard financial planning will tell you that the solution is to maintain a sizable allocation to equities, assuming that you will sell off about 4% of your portfolio per year. At a 4% withdrawal rate, you can "safely" assume that you won't outlive your assets.

Well, that sounds good. But there is one little problem with it. The market, as measured by the cyclically-adjusted P/E ratio, is very expensive today at about 25 times a rolling ten year average of earnings. Corporate profits are also at record highs, and inflation and interest rates are still very low and have little space to fall further. In this environment, do you want to bet your retirement on capital gains that may never materialize?

A better approach is to use a Dividend Growth strategy as the core of your portfolio. In an ideal dividend growth strategy, you assemble a portfolio of stocks that offer a current yield that is competitive with competing income instruments (such as bonds) and - most importantly - offer a strong probability of rising dividends. As a general rule, I like to see stocks that have at least five consecutive years of rising dividends, and ideally I like to see that they have survived a deep recession with their dividend intact.

On this count, most banks currently fail to make the grade. Though as the sector emerges from years of government scrutiny and with cleaner, less-leveraged balance sheets, they're now on my radar.

Disclaimer: This site is for informational purposes only and should not be considered specific investment advice or as a solicitation to buy or sell any securities. Sizemore Capital personnel and clients will often have an interest in the securities mentioned. There is risk in any investment in traded securities, and all Sizemore Capital investment strategies have the possibility of loss. Past performance is no guarantee of future results.