The following banks are subject of this post: Ally Financial (ALLY), American Express (AXP), Bank of America (BAC), BB&T (BBT), Bank of New York Mellon (BK), Capital One Financial (COF), Citicorp (C), Citizens Financial Group (CFG), Comerica (CMA), Discover Financial (DFS), Fifth Third Bancorp (FITB), Goldman Sachs Group (GS), Huntington Bank (HBAN), JPMorgan Chase (JPM), KeyBank (KEY), Morgan Stanley (MS), M&T (MTB), Northern Trust (NTRS), PNC Financial Services (PNC), Regions Financial (RF), SunTrust Banks (STI), State Street Corporation (STT), US Bank (USB), Well Fargo (WFC), and Zions Bank (ZION).
It should be noted that Goldman Sachs has made no public statement about its plans to return capital, although it did release a statement on June 22 regarding the Stress Test.
It also should be noted that Capital One ran into some apparent problems with its Stress Test exam as it is required to resubmit its capital plan by year-end. This cannot be good.
Chart 1 shows the results of the recently announced CCAR findings for each bank. Banks will return capital to shareholders two ways: share buybacks (repurchases) and dividends. JPMorgan Chase is expected to return $27.5 billion through a combination of newly announced share buybacks and an increase in its dividend. Bank of America, Citicorp, and Wells Fargo all are expected to return in excess of $15 billion each.
Chart 2 compares the Stress Test approved buybacks and dividends to each bank’s market capitalization at close of business July 5, 2017. According to this chart, the average bank is expected to return 7.2% of market capitalization to shareholders in the form of buybacks and dividends over the next year.
Leading the way are Regions Bank, Discover Financial, Citicorp, and Ally. The laggards are Goldman Sachs (as previously explained), Northern Trust, US Bank, and Huntington.
Of course, actual results may vary depending on the exact price each bank pays for its shares. The chart below assumes prices do not change from July 5th.
Of course, there is no guarantee bank stock prices will rise just because a bank plans to buy back shares. Just to provide some perspective, let’s analyze Citicorp’s trading history. The bank expects to buy $15.6 billion shares. At $67.50 per share, that means the bank would repurchase 231 million of its 2.75 billion shares. According to Morningstar, Citicorp averages 17 million shares traded each day which is equivalent to 4.25 billion shares traded in a year. In other words, Citicorp’s buyback represents “only” 5% of the expected share volume for the next year.
While 5% may seem small, one of the great challenges with buybacks is that banks have a history of repurchasing shares when banks are healthy and their valuations relatively high. This can be a problem for the long-term shareholder. Unlike Warren Buffett who has strict buyback guidance for Berkshire Hathaway shares, no bank has expressed, to my knowledge, similar guidance.
Bank investors may recall that prior to the Great Panic of 2008-2009, banks were aggressive buyers of their stocks at greatly elevated prices. Many of these banks turned around a few years later to issue new shares at reduced prices, thus diluting the interests of long-term shareholders.
I would strongly prefer banks not buy back shares if the stock price is not a good value. Certain banks face this concern today as will be addressed shortly.
Chart 3 breaks down each bank’s expected return of capital. As the chart shows, the majority of banks will return most of their capital via buybacks. Only Huntington plans to return more capital via dividends. My theory on Huntington, a bank in which I have invested as well as written about in the past on these pages, is that the bank will announce a major acquisition in the next year. My guess is that Huntington’s CEO and board intend to keep its ammo dry in anticipation. The bank has earned the right to go that route by virtue of its highly successful in-market acquisition of First Merit which closed in 2016.
Chart 4 indicates that the average bank will have a 2.18% dividend yield assuming dividends are paid out as anticipated and stock prices remain the same as July 5th close. Huntington is the only bank with a yield over 3% while BBT, SunTrust, and Wells Fargo are close.
Chart 5 begins the heavy lifting in this post. In this chart, two data points are compared.
First, the horizontal axis represents the data from chart 2: expected buybacks plus dividends as a percentage of each bank’s market cap as of July 6, 2017. Second, the vertical axis represents what I call the “Graham Multiple.” Derived from Warren Buffett’s mentor, Benjamin Graham, the Graham Multiple is the product of a company’s P/E times its Price-to-Book.
In Graham’s classic, The Intelligent Investor (see chapter 14, “Stock Selection for the Defensive Investor”), he suggests two rules of thumb for value investors: 1) the P/E should be no greater than 15:1 and the 2) Price-to-Book should be no greater than 1.5:1. He then goes on to write that “the product of the multiplier times the ratio of price-to-book should not exceed 22.5.”
Chart 5 highlights three banks in the color green: Regions, Citicorp, and Ally. These three banks are the only banks that have a Graham Multiple below 22.5 and a plan to return capital of 10% or more to shareholders over the next year. By virtue of this math, shareholders in these banks have the potential to be the big winners from the Stress Tests. Just missing the 22.5 Graham Multiple cutoff is Discover which has a multiple of 22.8 as of July 6.
Four banks are highlighted in red: Northern Trust, US Bank, Goldman Sachs, and Capital One. The latter two have been already addressed. Both Northern Trust and US Bank appear richly priced with Graham Multiples of 33 and 56, respectively. In addition, neither is expected to return more than 6% of shareholder capital over the next year.
It is possible that the reason US Bank's and Northern Trust's directors did not ask for more buybacks is because they do not want to use valuable capital to repurchase very expensive shares. If true, it is too bad the two banks did not choose to forego share buybacks in favor of a special one-time dividend to shareholders. Investors in these banks are likely to miss out on the bank investor party expected to occur when banks start buying back stock in earnest.
Chart 6 is the same as chart 5 but replaces the vertical axis with a one-year forward view of the banks’ Graham Multiples. Just to clarify, the Price-to-Book remains the same as in chart 5, but the P/E assumes earnings for the next four quarters as estimated by analysts who follow each bank.
This chart not only continues to show the relative attractiveness of Ally, Citicorp, and Regions, but also picks up two additional groups of banks that may have special interest to bank investors.
Fifth Third and JPMorgan Chase are highlighted in green; each has one-year forward Graham Multiples less than 20:1 and plans to return capital of at least 8% of current shareholder market cap.
Also highlighted in green are Citizens Financial, Morgan Stanley, and Bank of America. Each has a one-year forward Graham Multiple less than 15:1 and plans to return to shareholders capital equal to at least 6% of current shareholder market cap.
The final chart in this post measures the change in stock prices seen among the 25 banks since the June 28 market close. This date was chosen since banks were given the green light by the Fed to release details about their capital activity after the market closed that day.
Chart 7 shows that bank stocks are up a healthy 2.6%. But note the variation among the banks.
The top bank is Regions – no surprise given the prior charts. Citibank, Bank of America, Citizens Financial, Fifth Third, Huntington, JPMorgan Chase, and Morgan Stanley have all seen their stock prices go up between 4.1% and 4.7%.
The five lowest performers are Ally, American Express, Discover, Capital One, and US Bank. Since four of the five are specialty retail lenders (though Capital One might try to argue otherwise), it appears the market is worried about auto and card lending. As I wrote in February, auto lending risks are on the rise.
However, that said, while I would not be a buyer of American Express, Capital One, or US Bank, both Ally and Discover appear intriguing. My sense is that the Fed would never have allowed Ally or Discover to buy back so many shares and increase dividends as proposed if regulators had serious concerns about either bank’s solvency. That said, neither meets my investment criteria but I can see a case for buying each.
Study all the numbers, and investors can draw one key conclusion: banks continue to hold plenty of capital. In fact, I would argue the vast majority of banks continue to be well over-capitalized.
The big spike in dividends and buybacks is a catalyst for banks to continue to create shareholder value. If earnings and buybacks go as planned, expect most of the 25 banks to grow into their current valuations.
The big winners from this round of Stress Testing are shareholders in Regions, Citicorp, and arguably Ally. I would not be surprised to see Ally attract a prominent investor or two in the near future assuming the economy and consumer balance sheets gain forward momentum.
Other winners include Bank of America, Citizens Financial, Fifth Third, JPMorgan Chase, and Morgan Stanley.
The big losers are Capital One, US Bank, and Northern Trust.
Disclosure: I am/we are long JPM, CMA, HBAN. 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.
Additional disclosure: As a former Bank of America executive, while owning no shares in BAC, I continue to have certain financial interests in BAC.