Bank stocks are soaring, but now it’s time to go for quality

It’s not too late to buy bank stocks, which have shot up in the past few weeks, but you had better stick with quality companies to lower your risk.

Bank earnings season is about to begin, and most of the news will probably be good. This includes excellent loan quality as the economy continues to grow, and widening spreads as interest rates on loans have risen while rates paid on deposits have remained very low.

So bankers expect their fundamental “spread” business to continue to improve. Restrictions in certain areas of lending have curtailed business after regulators implemented the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. That has benefitted business-development companies, for example, which have been able to expand their non-real estate lending to medium-sized businesses, as leveraged lending rules have forced banks to pull back in this area.

John Bowman, a partner at Dinsmore & Shohl LLP in Washington and a former director at the Federal Deposit Insurance Corp., doesn’t expect any legislation from Congress to ease banks’ regulatory burdens.

But during an interview on Tuesday, Bowman said “leveraged lending is one of those areas for greater regulatory discretion to be applied.”

That means bank examiners might be able to allow banks to participate more in traditional areas of commercial lending that have been curtailed since Dodd-Frank was passed, in part because it has become easier for regulators to use technology to monitor banks’ loan quality.

Large banks are also subject to annual reviews of capital plans by Federal Reserve examiners, and their boards of directors hope for an easing of restrictions on how much excess capital they can deploy through dividends and share buybacks. But Bowman doesn’t expect much change on that front.

Also see: Bank earnings: ‘lower for longer’ means buybacks will continue

He said that when bankers try to persuade regulators to ease their capital requirements, “it is harder to argue that ‘we cannot pay a dividend’ than it is to argue that you cannot make enough loans because the capital rules are too tough.”

So rather than looking forward to banks paying higher dividends and buying back shares, maybe investors should look forward to banks doing more banking.

A subsector that’s heating up

Before showing you a list of quality bank stocks, here’s how the S&P 500 banking subsector has performed this year against the S&P 500 Index

SPX, +0.14%

:

FactSet

The S&P 500 banking sector lags the broader index this year, but has been coming on strong lately.

So the banks have underperformed the index, but not by much, and you can see on the right side of the chart that banks have been on a tear recently. Here’s the same comparison, but for the past month:

FactSet

On Thursday, J.P. Morgan Chase & Co.

JPM, -0.49%

 is expected to show a 7% increase in third-quarter earnings per share, according to consensus estimates among analysts polled by FactSet. On Friday, Bank of America Corp.

BAC, -0.60%

is expected to post a 12% increase in EPS, while Wells Fargo & Co.

WFC, -0.03%

 is expected to report EPS that’s flat.

Of course, long-term investors shouldn’t hang their hats on any quarter’s earnings, especially during what can only be considered the good part of the economic cycle for banks.

With bank stocks coming on strong, you need to consider whether their valuations might be getting too frothy. The S&P 500 banking sector trades for 12.9 times weighted aggregate consensus 2018 earnings estimates, according to FactSet. That is 74% of the forward P/E ratio (based on 2018 EPS estimates) for the entire S&P 500, which is fairly close to the 70% valuation for the banks that most analysts would ordinarily expect.

A year ago, the S&P 500 banking sector traded for 11.1 times consensus 2017 EPS estimates, while the S&P 500 traded for 16.2 times. So everything has gotten more costly, but the valuation comparison is similar.

Looking ahead, with so many large companies hitting new earnings records and the U.S. economy continuing to expand, it should be no surprise to see the Dow Jones Industrial Average

DJIA, +0.14%

 and S&P 500 hitting new highs. But if you want to play the bank stocks, going for quality can offer you some protection during the inevitable declines.

So we looked at the 24 stocks of major banks included in the KBW Bank Index

BKX, -0.38%

 and the 50 banks included in the KBW Regional Bank Index

KRX, -0.75%

If you buy shares of a bank, you want it to grow, while maintaining solid loan quality and the best possible spread between interest income and funding costs. You want the bank to operate as efficiently as possible. Over long periods, everything can be boiled down to return on equity. If this is high, the bank has excess capital to use for expansion or to deploy through dividends and share buybacks. All of those things can push the share price higher, or at least make you sleep easier, if you think you think current stock prices may be too high.

We boiled down the two bank indices to a list of 10 banks that have had the best average returns on common equity (ROCE) over the past four reported quarters:

Company Ticker Headquarters Average ROCE – past four reported quarters, through Oct. 9 Minimum ROCE Maximum ROCE
Bank of Hawaii Corp.

BOH, -1.02%

Honolulu 15.75% 15.42% 15.98%
Western Alliance Bancorporation

WAL, -1.08%

 

Phoenix 14.92% 14.74% 15.06%
East West Bancorp Inc.

EWBC, -0.89%

Pasadena, Calif. 13.79% 12.80% 14.61%
U.S. Bancorp

USB, -0.07%

Minneapolis 13.49% 13.31% 13.57%
Bank of the Ozarks

OZRK, -2.49%

Little Rock, Ark. 13.12% 11.48% 14.26%
First Financial Bankshares Inc.

FFIN, -1.20%

Abilene, Texas 12.47% 12.22% 12.75%
Wells Fargo & Co.

WFC, -0.03%

San Francisco 11.73% 11.55% 11.94%
First Republic Bank

FRC, -0.63%

San Francisco 11.41% 11.37% 11.53%
Northern Trust Corp.

NTRS, +0.51%

Chicago 11.37% 11.21% 11.44%
Signature Bank

SBNY, -1.34%

New York 11.37% 9.27% 12.19%
Source: FactSet

It’s interesting to see Wells Fargo on the list. Over the past five full years, Wells Fargo has been the best performer among the “big four” U.S. banks, with an average ROCE of 13.08%. As you will see on the next table, Wells Fargo’s stock has not performed well this year, as the company still hasn’t solved its public- and political-relations problems.

Here are forward price-to-earnings ratios for the group, along with total returns for this year:

Company Ticker Closing price – Oct. 9 Consensus 2018 EPS estimate Forward P/E ratio Total return – 2017, through Oct. 9
Bank of Hawaii Corp.

BOH, -1.02%

$84.32 $4.78 17.6 -3%
Western Alliance Bancorporation

WAL, -1.08%

 

$53.18 $3.54 15.0 9%
East West Bancorp Inc.

EWBC, -0.89%

$59.82 $3.82 15.7 19%
U.S. Bancorp

USB, -0.07%

$53.85 $3.78 14.3 7%
Bank of the Ozarks

OZRK, -2.49%

$47.42 $3.49 13.6 -9%
First Financial Bankshares Inc.

FFIN, -1.20%

$45.45 $1.84 24.7 2%
Wells Fargo & Co.

WFC, -0.03%

$55.14 $4.40 12.5 2%
First Republic Bank

FRC, -0.63%

$104.66 $5.26 19.9 14%
Northern Trust Corp.

NTRS, +0.51%

$92.65 $5.29 17.5 5%
Signature Bank

SBNY, -1.34%

$124.02 $9.75 12.7 -17%
Source: FactSet

Wells Fargo appears to be a bargain stock, as long as you believe the worst of the company’s scandals are behind it.

Signature Bank of New York has been the worst performer this year among the listed companies, as it has placed all of its loans secured by taxi medallions on “non-accrual,” which means the bank does not expect the loans to be fully repaid. Taxi medallions were traditionally considered to be safe collateral in New York, as the limited supply made their value increase. Until Uber came along.

But after taking a $187.6 million provision for loan losses during the second quarter and charging off $229 million in loans (mostly taxi medallion loans), the bank was left with $393 million in non-accrual loans as of June 30. Those made up 1.29% of total loans, and loan loss reserves covering 46% of non-accrual loans. So the worst seems to be over, but the bank may have another rough quarter or two ahead if it makes additional provisions for loan loss reserves.

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