- Inflation is probably coming at least for the short term.
- Banks usually suffer during high inflation.
- Citigroup is cheap, offers margin of safety and low payout ratio, and can be a good pick in the sector.
As a dividend growth investor, I am always looking for dividend growth stocks that can fit into my strategy. The fear of another financial meltdown during the pandemic sent stocks in the financial sector spiraling downward, and as of right now we see that the companies are not suffering from significant losses, the recovery will take time, and fiscal stimulation is crucial.
Banks are stronger than ever, today when it comes to their balance sheet. Therefore, they survived the covid recession so far. The Federal Reserve has allowed them to continue buybacks, and dividends are likely to grow again in 2021. In my opinion, the most interesting uncertainty for banks right now is inflation, and I believe that the bank that will be the most attractive during a high inflation environment is Citigroup (NYSE:C).
Inflation is a challenge for banks. Banks make money by selling loans, and if inflation is high then real interest might be extremely low, and even negative thus hurting earnings growth. Therefore, I believe that during inflation, investors should focus on the banks that currently offer a wide margin of safety, and among the largest banks in the nation, Citi is my choice.
According to Seeking Alpha company overview, Citigroup provides various financial products and services to consumers, corporations, governments, and institutions in North America, Latin America, Asia, Europe, the Middle East, and Africa. The company operates in two segments, Global Consumer Banking and Institutional Clients Group.
Inflation is coming
We start seeing lately more and more signs that the inflation rate is going to rise in the coming year. The Personal Consumption Expenditures Price Index is slowly ticking upward, and it starts to look like the inflation rate will reach an inflation rate higher than 2%, which is the target of the Federal Reserve. This is one of the reasons that we see bonds yield ticking upward as well.
We hear many financial experts discussing inflation. We see fund managers like Cathie Wood discuss it, and we also hear the regulators discussing it both Jerome Powell, the chairman of the Federal Reserve, and Treasury Secretary, Janet Yellen. However, they are all downplaying the risk of inflation, and we even heard Bostic saying that even if inflation goes higher, it is fine as long as it is stable.
Investors therefore should take inflation into account. They should make sure they invest accordingly, and they should be cautious. While the regulators believe that the inflation will be higher only for the short-term, I'd like to remind us all, that nobody thought that zero interest rates will be here for so long. Therefore, while I believe that there are enough tools to limit inflation if needed, investors should be cautious.
Some assets are more sensitive to inflation. Bonds for example tend to go down more than stocks during inflation, and that makes sense as the interest payment is consumed by the inflation, and while companies can raise prices, bonds are fixed income, and their returns are fixed. The banking sector is one sector that gets hurt from inflation due to its reliance on loans, and we already saw banks struggling to meet their net interest income goals.
Inflation and Banks
Banks make a significant income from the interest rate and the reason why they are sensitive to inflation is the formula below where i is the nominal interest rate, r is the real interest rate and pi is the inflation rate. The higher the inflation the lower the real interest rate, and as soon as inflation ticks higher than the nominal rate, the banks will be lending money for negative real interest. That's why many studies show, that inflation has a negative impact on banks' earnings.
Israel is an example of an economy that suffered from very high inflation in the 1980s. Therefore, Israeli banks are also selling loans with lower rates, but the interest and principal are tied to the CPI. These loans are not popular in the U.S, and if inflation will rise, it will hurt the banks' real earnings significantly.
Alchian and Kessel found decades ago that inflation is bad for banks. In my opinion, nowadays the effect is going to be harsher. In the past, the loan portfolio suffered, but on the other hand, they paid lower real interest on deposits. Today banks already pay almost 0% on deposits, and they can't charge negative interest rates as they did in some European countries, since clients have more options today.
Clients today can buy cryptocurrency or any other foreign currency, or they can save their money in a digital wallet such as the one offered by Cashapp (SQ) or PayPal (PYPL). The larger clients have more negotiation power and can move to a different bank, therefore, in our global world, banks will find it harder to deal with inflation using their deposits.
The strong fundamentals are the first reason that Citigroup is a good investment. The company didn't see significant sales growth in the last five years, yet up until the pandemic the company managed to become more efficient and profitable and achieve significant bottom-line growth. Moreover, as the economy recovers it is forecasted that Citi will enjoy growing top and bottom line in the short-term.
Also, Citigroup was very weak during the 2008-9 financial crisis, have passed the stress test in December 2020. The company is not as leveraged and has more than enough liquidity to survive the significant downturn. Therefore, I see here top and bottom-line growth, as well as less risk, and that's one reason I like Citigroup at the moment.
(Source: Seeking Alpha)
Citi doesn't only have strong fundamentals and ample cash, it is also undervalued as it trades for 10 times its 2021 earnings and 76% of its book value. When I compare Citi to other peers such as Wells Fargo (WFC), Bank of America (BAC), and JPMorgan (JPM) Citigroup offers the best valuation. The combination of good valuation, together with the low leverage, high liquidity, and top and bottom-line growth make Citi attractive.
The reason Citigroup suffers from the low valuation is its low profitability and return on equity. The company has been lagging its peers for the last decade, and therefore investors who agreed to pay an 80% premium for JPMorgan are only willing to pay less than book value for Citigroup. However, while investing in JPMorgan and the most profitable banks is more conservative, investing in Citigroup as it improves its ROE, as seen in the graph below, gives investors more upside.
The company is also very shareholder-friendly. The buybacks have decreased the number of shares outstanding by almost one-third in the last five years, and in the meantime, the company pays an annual dividend of over 3%, which is extremely safe. The lower payout ratio is crucial if there will be inflation, as it will allow the company to raise the dividend at a pace higher than the inflation rate, so income investors don't suffer from real dividend decreases.
The company offers the largest margin of safety among the big banks. Growing fundamentals are not unique, yet the current valuation gives the edge here. If we go to a challenging time for banks, the other peers have a larger downside due to their valuation. For Citigroup for example, due to its lower valuation, to begin with, investors get a very decent margin of safety, so even if inflation hits earnings, they will have more margin. During uncertain times I always pick the safest investments. We saw that when the markets were more volatile last week, companies that traded for high valuation were to first to suffer. If inflation will become an issue, and bond yields will keep climbing, we will see this trend continues.
The banking sector suffers from inflation, and investors should prepare for inflation. When a sector might get hit, I would rather pick with safest and most undervalued stocks in the sector, as during uncertain times margin of safety becomes even more important than it usually is. Uncertainty can cause major swings in prices of shares, and thus I believe that Citigroup with its current valuation offers the largest margin of safety among the banks.
Moreover, the reason for the valuation is the low ROE, Citigroup is working on becoming more efficient and more profitable so it also has more upside, as JPMorgan for example enjoys ROE which is almost twice as high. So investors have margin of safety, upside in case of improving conditions, and above all the company has strong fundamentals which support both dividend growth as well as stock buybacks. That's why Citigroup is my favorite major bank if inflation comes.
This article was written by
Analyst’s Disclosure: I am/we are long C, SQ, PYPL, BAC, JPM. 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.
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