Inside Financial Services

The Bank Stock Bull Market Is Alive and Well

"Credit recovery" banks most attractive of all. Also BofA. That's right, BofA.

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Twenty-eight months into the bull market that started in March of 2009, the S&P 500 has risen by 97%. Believe it or not-and this might come as a surprise to some of you-the financial stocks have actually participated in the rise! The S&P Financials are up by 149% from their lows, while the KBW Bank Index is up by 161%.

Yet despite that outperformance, the financials don’t have a lot of fans among investors. Take a look at the holdings of the 25 largest U.S. equity mutual fund managers. Almost all of them are underweight financials, particularly the banks. And more recently, the financials and the banks have both lagged. The financials have pulled back by 14% from their recent high while the banks are off by 21%, compared to just a 4% pullback in the S&P 500.

I mention all this to provide some context for the view I’ve had of the stock market (and the financials in particular) for some time: the bull market in stocks still has a long way to run. Banks, I believe, will be at the forefront.

In the last month, I’ve had the chance to sit down and talk about the financials with two of the greatest investors of our lifetime: Bill Miller of Legg Mason and Chris Davis at the Davis Funds. Both are of course long-term, value investors-and both are very positive on the group.

Let’s focus on the banks, first. I’ve said for some time that the bank stock bull market would have three legs. The first lasted a year, and reflected investor recognition that the banking system wasn’t going to collapse, after all. The second, which we’re in now, would be driven by a return to normalized earnings and valuations. The third leg of the rise will be driven by the deployment of banks’ excess capital.

As I say, we’re in the middle of the second leg now. Sure enough, the early second-quarter reports that have come out have shown that the banking industry’s earnings are recovering strongly, as credit problems ease and economic activity picks up generally. Yet earnings recovery or not, the valuations of many banks, especially the ones that were most stressed by credit, haven’t expanded much from where they were at the depths of the crunch.

So the most attractive opportunity I see in the group today is in what I’ll call “credit-recovery” banks. These are the banks that had severe credit issues that are being steadily fixed. My favorites are companies in the $1 billion to $30 billion asset size where we’ve done extensive work on credit, and have confidence that recoveries are real and durable. Among our favorites (both of which we own, by the way) are Citizens Republic (CRBCD) and Mercantile Bank (MBWM). Both should report strong recovery earnings over the next two weeks. What’s more, in coming quarters they should recover huge deferred tax assets, which will significantly boost their GAAP tangible book values, as they demonstrate sustainable profitability.

Among the big banks, meanwhile, one name among our positions deserves a mention: Bank of America (BAC). Longtime readers know that I haven’t had a lot of good things to say about BofA for, oh, the past 20 years or so. Even now, no one will confuse BofA with a growth company. But the stock has gotten hammered so badly that BofA’s franchise is worth considerably more than the company’s current market value.

To see what I mean, take a look at one quick-and-dirty bank valuation measure: market cap plus preferred as a percentage of assets. Among the big banks, BofA is at the bottom of the heap:

Selected Banks
Market Cap plus Preferred as a Percentage of Total Assets

U.S. Bancorp

16.5

Wells Fargo

12.5

Average, all banks over $1 billion

11.3

JPMorgan Chase

8.0

Citigroup

6.4

Bank of America

5.6

On other standard valuation measures, BofA sticks out, as well. The stock trades at 5 times its normalized earnings, and 76% of its tangible book value. There’s no doubt, then, that investors aren’t optimistic about the company’s long-term earnings outlook.

Those doubts notwithstanding, the fact is that the company faces only one major-and well-known- problem: its credit and legal exposure to future residential mortgage loan losses. I won’t go into a detailed discussion here of why I believe future losses from litigation not already taken or reserved for are manageable (they’ll be under $10 billion I believe). But if you want to read some great research on the topic, take a look at the work that’s been done by John McDonald of Sanford Bernstein.

If you can get comfortable with BofA’s future residential mortgage loan costs, the company has a lot of things going for it that investors don’t seem to be properly appreciating.

1. Powerful pre-tax, pre-provision earnings. BofA currently earns close to $40 billion a year pre-tax, pre-provision, and pre-mortgage litigation costs. This is the fuel that will enable the company to burn through future mortgage related expenses.

2. BofA has already put aside huge reserves for mortgage losses and related litigation costs. The company has a $ 40 billion loan loss reserve and several billion dollars worth of litigation reserves. The former is already coming down, and that will continue for several quarters, which should in turn drive higher earnings. The latter will come down when the end of the mortgage mess is in sight.

3. Credit is improving. Commercial and consumer credit, ex-residential mortgage loans, is clearly getting better. This trend should continue. Even mortgage delinquencies appear to have peaked.

4. BofA’s net interest margin is set to improve. No other bank I know of has as high a percentage of its funding mix be long-term debt. This debt should decline all year, which would help the company’s margin this year and next.

5. Bank of America has an efficiency plan in place. After credit improvement, BofA’s highest priority is better cost efficiency-and the company has put in place a major initiative to achieve it. The positive impact from this effort will be seen in coming quarters.

BofA of course has some challenging longer-term problems. I am not suggesting otherwise. What I am suggesting, though, is that the negatives are well-reflected in the company’s valuation, while the positives (and there are more than a few) are not.

Catalyst?

“So what’s the catalyst?” for bank stocks overall, or Bank of America in particular, investors will often ask. Usually I answer, “Who knows?” It’s hard enough to find attractive investment opportunities. Predicting what will make them go up is impossible. For value investors like Bill Miller and Chris Davis, the catalyst is simply BofA’s incredibly favorable risk/reward profile. Some day down the road-who knows when?–some relatively insignificant event will occur that will cause investor sentiment to slowly begin to change, and BofA’s valuation will at last start to edge higher. Smart value investors don’t wait for that unpredictable moment.

Banks vs. Tech

Investor sentiment toward the banks today versus the tech companies reminds me of 1999. It’s crazy! Either banks are undervalued or certain tech stocks are overvalued, or both.

Let’s take one example. Fifth Third (FITB) has a market cap of $11 billion, while LinkedIn has a market cap of $10.4 billion. Fifth Third trades at 1.5 times its revenues, while LinkedIn trades at 43 times revenues. When Fifth Third reports its earnings-yes, earnings–this week, they’ll be higher than the revenues LinkedIn is apt to generate for the entire year! In fact, Fifth Third will pay out more cash in dividends to shareholders this year than LinkedIn’s revenues will be for all of 2011!

Just like in 1999, the valuation disparities that exist today between the banks and some tech companies (either public or soon-to-be-public) likely are not sustainable. And just like in 1999, I can’t tell you when the mismatch will end, but it will, that’s for certain. In the meantime, I like the investment risk/reward tradeoff today much better owning bank stocks-even one I haven’t liked for decades, Bank of America.

What do you think? Let me know!

24 Responses to “The Bank Stock Bull Market Is Alive and Well”

  1. DK

    Tell us again why SNV was such a screaming buy. That’s been beaten and left for dead.

  2. JTaylor

    good stuff, thanks for taking time to pen your thoughts.

  3. Mike Kayes

    If you “normalize” BAC it is one of the leading financials. Perhaps a more appropriate comparison to gauge the relative vlaue between financials and tech stocks would be to compare BAC and one of the leading tech companes, AAPL? The $40 billion pretax, pre provision, pre litigation might sound fine, but these items matter and no one has any confidence predicting the last two. Moynihan is building a track record of over promising and under delivering. In comparison, AAPL’s operating income will approach $50 Billion next year and the stock is selling at less than 13X 2012 eps estimate. That is far from expensive and the estimates have been too low for years.

    BAC peaked at 55 in 2006, fell 94% to 3, and has rallied about 300% to 10. Doesn’t quite seem like a bull market to me. More like a dead cat bounce.
    Mike Kayes
    Willingdon Wealth Management

  4. jerele

    Tom, as a long time investor in BAC, since 1990 I hope you are right. In this difficult financial environment and the vast overhanging mortgage questions it is difficult to be optimistic. As a retired banker I fear that banks are being viewed by politicians as the utilities of the future. Also the Attorney Generals of many states and especially NY scare me. Remember when Ken Lewis was picked the banker of the year in 2008 by the American Banker.

  5. Parks

    Does Snv fall into this or any other list for you?

  6. Doug

    Tom,
    I hope you are right about bank stocks. I own USB, WFC and JPM. I remain skeptical about BAC. Good article about BAC and CEO Moynihan in current issue of Fortune.

  7. Doug

    Tom,
    I hope you are right about bank stocks. I own USB, WFC and JPM. I remain skeptical about BAC. Good article about BAC and CEO Moynihan in current issue of Fortune.

  8. TJ Schoenlein

    I couldn’t agree more with you on BofA… of course we are in the small minority. Seldom do you see so much “hate” for banks and BofA seems to be the number one bad boy. I’m over weighting BofA, C, CS, LYG & BBT. Patience/discipline is on tap now.

  9. mopedman

    And the thing that will cause sentiment on bank stocks to change the fastest..is the price going up. Right now IMO, BAC is your one day stock if you want that to happen. It’s going to take a few times of people realizing they messed up by doing that instead of knowing they played it perfectly. It’s not a new toy, nor a way to propel you, or the way the future is changing. It’s just stodgy old banking. Nevertheless if it’s cheap, if it doesn’t go belly up, doesn’t get bought out, and you just wait, what the past tells you is it will sometime happen. Two? three? years out it’s far easier for me to see a $2.00 bank stock at $10 than an earth moving stock at $668.75. Might even go back to Honolulu and eat at McDonalds again.

  10. Phantom Gremlin

    Plenty of critical comments from the peanut gallery. But Tom puts his thoughts out there for all to see (OK, so he’s talking his book). What about the critics? How about links to your websites so we can see how well your recommendations are doing?

  11. JRG

    The entire banking sector is dead money. The reasons:

    Significant excess capacity and capital.

    The deleveraging of consumers and businesses.

    The regulators will not allow banks to engage in high risk activities like they have in the past to meet growth goals. I think this time they will get it right

    The critical factor is an inability to grow revenues. Where is the revnue growth going to come from? All the sectors that fueled growth in the past are gone – commercial real estate, second mortgages, LBOs. That leaves traditional commercial and consumer lending being fought over by all this excess capacity. . This will be charcterized by competition on price and terms like it always has further driving down profitability. The story I hear from community banks is that they all want to grow their commercial lending businesses because investment CRE is gone. Just more competition ia already over banked sector.

    If someone can demonstrate a compelling revenue story for a particular bank I would love to hear it. It has to be more than taikng market share and superior customer service

  12. Sam

    All you critics out there just don’t get it. Your right, things have gone terrible for financial stock. Thats when buying becomes interesting. Go ahead and invest in stocks like LNKD. Long term the banks will be good investments

  13. mmn

    I notice that you mention Citizens Republic and Mercantile Bank. Whatever happened to Synovus and Taylor Capital?

  14. Victor

    Tom, your second leg for the bank recovery included “a return to normalized earnings”. Buffett recently remarked that the earnings power of banks will be “considerably reduced” compared to the past. Given the new legislation, that seems reasonable. How does that likelihood factor into your thinking?
    Victor

  15. Rbphillips

    You are an idiot to push these crooks onto innocent people. Boa has plenty of cellmates for Bernie madolf and it is just a matter of time before the cookie crumbles. Someday boa will just be a memory.

  16. johnny

    To all of you who followed Tom into BAC – how are you feeling now??

    Oh, and SNV on its way to $1.

    Bull mkt is officially over.

  17. Blowhard Billionaire

    Once again, Mr. Market proves that to be an icon on Wall Street is a matter of luck rather than any skill. Witness Davis, Miller, Paulson, Berkowitz, etc. Hopefully the American investment consumer has finally figured this out. BAC should have been allowed to die a quick death back when empty suit Ken Lewis made the biggest blunders in banking history. Instead we have another wave of investors seeing their investment destroyed while BAC’s latest empty suit executive tries to divert from the obvious truth that BAC’s balance sheet is still a house of cards.

    At this point, the bank needs to be broken up and put out of its misery.

  18. johnny

    Well said, Blowhard, well said. Even an unsophisticated investor could figure out that BAC and SNV were doomed a long time ago.

  19. johnny

    The BKX hit its recent high just several days after Tom published this note. I should have known – contrarian indicator!

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