U.S. bank stocks are a good investment

Still cheap after the sub-prime mess, U.S. financials are poised to rebound in a big way.

(Photo: Jb Reed/Bloomberg/Getty Images)

Here’s one more sign the U.S. economy is getting back on track: the banks are starting to call the shots again. On March 13, Jamie Dimon upstaged—some would say told off—the U.S. Federal Reserve by revealing that the bank he runs, JPMorgan Chase, had essentially passed its government-mandated stress test. The announcement was supposed to have taken place two days later, but Dimon, who has a history of picking fights with central bank chairmen (including our own) decided not to wait. JPMorgan, he said, would increase its dividend by 5¢ a share and would repurchase US$15 billion of stock over the next two years. Immediately after the 3 p.m. announcement, JPMorgan’s share price ticked up, jumping 5% by the day’s close.

Other banks also saw their stock prices rise, especially after the Fed was forced to reveal—it hastily moved its announcement up by two days—that 15 of America’s largest 19 banks were allowed to increase dividends and buy back shares. These companies had passed their stress tests, which meant they were capitalized well enough to withstand another major crisis. While some analysts were annoyed by Dimon’s actions, there was no doubt what his statement really meant: the U.S. financial sector is coming back to life.

Many Canadians have been keeping a close eye on U.S. financials over the past few years. With the U.S. economy improving, Tim Lazaris, president and CEO of Toronto-based Red Sky Capital Management, says now is the time to buy. “If you think there’s going to be a recovery, the U.S. banking sector is a great place to be,” he says.

Canadians already own a lot of banks. Financials make up about 30% of the S&P/TSX composite index, so it’s difficult to avoid the sector. But U.S. financials provide two things that our domestic banks don’t: cheap valuations and growth. In Canada, there are only a handful of names. In the States, there are around 6,000 banks to choose from, although only a few have a national presence. David Dietze, president and chief investment strategist at Point View Wealth Management based in Summit, N.J., says continued consolidation in the industry means the mid-sized banks will tend to scoop up the smaller players to expand their reach and their money-making potential. Larger banks will also see growth as Americans find jobs and start saving—and spending—more money.

Right now, U.S. banks are a steal. The sector is trading at around 13 times earnings, while the broader S&P 500 is trading at around 14.5 times and Canadian banks, even higher. JPMorgan Chase is trading at around 10 times earnings, for example, and Wells Fargo is trading at about 11. “On a relative valuation basis, you’ll do better owning U.S. banks,” says Lazaris.

It’s still early days in the sector’s recovery, but share prices are starting to move. The prices of financial stocks on the S&P 500 have jumped 22% year-to-date. Nonetheless, many investment managers think there’s still plenty of room to grow. Joel Clark, managing partner and portfolio manager with Toronto’s KJ Harrison & Partners, says that in five years JPMorgan’s stock, which is trading at $45 today, will double, while Bank of America’s nearly $10 stock price will climb to $100 over the next 15 years (all figures in U.S. dollars).

The reason for this optimism is that the health of America’s banking sector is directly related to the state of the U.S. economy, and it appears the country’s financial fortunes are finally improving. Of particular relevance to banks, home foreclosures are down 8% year over year. The Federal Deposit Insurance Corp. said in February that insured banks reported an aggregate profit of $26.3 billion in the fourth quarter of 2011, up $4.9 billion over the year before.

For more risk-averse investors, buying the biggest names is the way to go. Lazaris says that many American banks operate in only certain regions, and unless you have a grasp of the economics of a particular state—which most Canadians don’t—he advises holding a large national institution with exposure to the overall recovery. When deciding which brand to own, Lazaris says the management team is important. See if it’s been able to successfully navigate its bank out of the recession; too much executive turnover is a bad sign. Also make sure the bank is well capitalized. That’s easy to do, says Dietze, because having a strong common capital ratio—a bank’s core equity capital compared to its total risk-weighted assets—of 5% is required to pass the Fed’s stress test. “Why second-guess the feds?” he asks.

When it comes to valuations, price-to-book value is the most important metric, says Dietze. This ratio reveals the value of the bank’s assets if there were an orderly liquidation of the company. Historically, many banks have traded up to two times book value; now they’re trading below, which is a sign that they’re undervalued. Price-to-earnings is also important to look at—lower is generally better—and you want a company that pays a dividend. “If you can get all three things, that’s a good value proposition,” says Lazaris.

Another way to play the sector is by owning a smaller-capitalization bank that’s either a takeover target or a potential acquirer. Anton Schutz, president and chief investment officer at Rochester’s Mendon Capital Advisors, thinks that over the next five years the number of banks will drop from around 6,000 to about 4,000. “There will be a huge amount of M&A,” he says. A lot of the smaller banks, he explains, will have trouble paying for the more rigorous regulation, so they’ll have to sell. It won’t be the big banks buying—the government doesn’t want them to get bigger, says Schutz—but rather medium-sized operations that want to enter new markets.

Whether it’s best to own the buyer or the seller depends on the economics of a particular market. In Florida, for example, you want to own the buyer because there’s not as much money flowing into the banks that are already there. Many are sick and could still fail. In Pennsylvania, where natural gas drilling has recently taken off, you want to own a seller because people there have money and are making deposits.

One risk you should be aware of is overexposure to the financial sector, says Lazaris. If Canadian financials already make up 30% of your equities and you want to put another 10% in U.S. banks—he recommends buying no more than that—then you should sell off some of your domestic holdings. But don’t wait too long. As the economy improves and people stop wondering if the banks will fail, investors will move back into the market en masse. “Now’s the time,” says Lazaris. “Every Canadian should seriously consider U.S. banks at this stage.”


The CB hotlist

U.S. Bancorp
(NYSE: USB) P/E: 13.14
P/B: 1.92 | 1-YR RET.: 20.93
Minneapolis-based U.S. Bancorp is one of the better-capitalized banks out there, says Red Sky’s Tim Lazaris. It wasn’t directly exposed to the sub-prime market and hasn’t made any unnecessary acquisitions.

JPMorgan Chase & Co.
(NYSE: JPM) P/E: 9.70
P/B: 0.97 | 1-YR RET.: 1.56
While New York–based JPMorgan Chase did suffer during the recession, the company quickly bounced back. KJ Harrison & Partners’ Joel Clark says the bank is really “the only game in town” with global reach. It’s a diverse, international business, filling a void left by struggling European banks.

Wells Fargo & Co.
(NYSE: WFC) P/E: 11.38
P/B: 1.39 | 1-YR RET.: 8.81
If JPMorgan is the best global bank, San Francisco–based Wells Fargo is the best domestic one, says Clark. It’s quickly gaining market share, partly due to smart acquisitions made during the recession, most notably Wachovia Corp.

Susquehanna Bancshares
(NASDAQ: SUSQ) P/E: 12.50
P/B: 0.72 | 1-YR RET.: 10.26
If you want to own a smaller bank that could be a takeover target, Mendon Capital Advisors’ Anton Schutz suggests owning this Lititz, Pa.–based institution. The company, he explains, is benefiting from the state’s strengthening economy, and its management team has successfully sold banks before.