Despite uncertainty about the eventual impact of major regulatory reform for the financial sector—and fears that further losses on bad commercial real estate loans loom—investors seem to be embracing bank stocks more willingly now.
The KBW Bank Index (BKX), a capitalization-weighted index comprising 24 geographically diverse stocks of national money center banks and large regional banks that is maintained by Keefe Bruyette & Woods, was up 20.4% year-to-date through Mar. 16 after jumping 129% between its Mar. 6 low and Dec. 31, 2009. For all of 2009, however, the index was actually down 3.6%.
Keefe Bruyette's equity analysts prefer larger banks that have repaid money they received under the Troubled Asset Relief Program (TARP) and are further advanced than smaller banks in providing for and taking losses. KBW now has an outperform rating on all large banks, and its favorite picks are Bank of America (BAC), JPMorgan Chase (JPM), U.S. Bancorp (USB), and BB&T (BBT), all of which were upgraded from a neutral rating over the course of 2009. But the stocks that have appreciated most in recent weeks are those that generally haven't yet repaid TARP money and that are perceived to be more vulnerable to further commercial loan losses, such as Regions Financial (RF) and SunTrust Banks (STI), says Jefferson Harralson, an analyst at KBW. For the year so far through Mar. 16, Regions shares were up 42% and SunTrust shares were up 35%.
"Those are more of a risk trade, in that investors are sensing that risk is diminishing, that we're farther through the credit cycle," he says.
Blessings of a Steep Yield Curve
Investors may be focused on bank earnings, which are expected to "rebound strongly as banks stop adding to loan loss reserves in 2010 and net interest margins benefit from the Fed holding interest rates unchanged and a steep yield curve through 2010," according to a Mar. 12 research note from Bank of America. David Bianco, chief equity strategist at BofA, said he prefers the large universal banks based on their higher loss reserves, smaller exposure to commercial real estate, and more diversified revenue streams from the capital markets, and he favors companies with a market cap of at least $20 billion.
With credit costs expected to moderate over time, Bianco said he sees banking as "big business" and suggested that investors overweight financials in their portfolios.
Investment banks that are leveraged to the capital markets are probably undervalued now, since "we're in the midst of what looks like a really strong capital markets environment," says Jeffrey Harte, an analyst who covers big banks at Sandler O'Neill & Partners in Chicago. Money center banks such as JPMorgan and Citigroup (C) also are likely undervalued now that major operating challenges seem less menacing, he adds.
"Investors should be looking at buying and owning investment and money center banks. As you move down from there, it becomes much harder—more of a stock picker's game and less a macro call," Harte says.
How Smaller Banks Are Vulnerable
Investors believe the next stage of pain from commercial real estate losses will be felt more by the smaller banks, says Harralson at KBW. So far, banks have recognized only one-tenth of the cumulative losses from commercial real estate loans that the market expected to see in the 2008-2010 period. Now the market is trying to figure out whether the losses were overestimated or are just coming more slowly than anticipated, he says.
Not everyone is wary of smaller bank stocks. The $200 million Polaris Global Value Fund (PGVFX) currently has a 20% weight in financials, and most of its domestic financial holdings are midcap or small-cap names. Fund manager Bernard Horn thinks smaller banks' share prices were pulled down by the drone of negative speculation about regulatory reform throughout 2009 more than by any concerns about specific company risks. Horn cites a huge performance gap between the stocks of large banks that recovered quite a lot in 2009 and small and midsize banks that in some cases fell 30% to 40%. That, he says, has created an opportunity.
"When you normalize earnings over time, that leaves small or midsize banks with much more upside to their stock prices than most of the large banks," he says. "We think the midsize banks may be one of most undervalued investments in the world."
Some of the best bets are strong banks capable of acquiring some of the failed banks in areas with the highest concentrations of problem banks, he says. Two examples are Southwest Bancorp (OKSB) in Oklahoma, a bank holding company that includes Stillwater National Bank & Trust and the Bank of Kansas, and Ameris Bancorp (ABCB) in Georgia, which recently acquired two failed banks. For this year through Mar. 16, Southwest shares were up 22.5%, while Ameris shares had risen 34%, with both stocks still trading under $10.
Horn predicts changes in four factors that have hurt bank earnings will eventually help stock prices rebound: a decline in net charge-offs and loan loss provisions, which for the midsize banks never reached the level they did for most of the large banks; a return of FDIC insurance premiums to lower levels; elimination of millions of dollars in preferred dividends banks are paying the government once TARP loans have been repaid; and a sharp reduction in the number of warrants the government received in exchange for TARP money as banks buy them back.
Elevated FDIC insurance premiums, in particular, have siphoned off large portions of commercial banks' earnings. (The agency began hiking premiums in October 2008 to help replenish its deposit insurance fund.) Premiums that once were a few hundred thousand dollars a year have jumped to the multimillion-dollar range and now consume nearly 20% to 25% of a banks' annual profit, says Horn. The failure of 165 banks in 2008 and 2009 pushed the balance in the FDIC's insurance fund to less than zero by September 2009. That prompted the agency to require that banks prepay premiums for the next three years at the end of 2009, taking an even larger bite out of profits. The time it takes premiums to come back down depends on how many more failures the FDIC has to absorb, but Polaris' models show that many banks are still greatly undervalued even if premiums never retreat, says Horn.
Receptive to Capital Raisings
KBW's Harralson agrees that TARP recipients will be better off once they have repaid the funds and no longer have to pay preferred dividends. But the number of new shares that banks will have to issue in order to raise the money needed to repay the TARP and how quickly they raise those funds could put more pressure on stock prices, he warns.
On the horizon is an abundance of capital-raising deals by banks eager to repay TARP money. The good news is that the market, still encouraged by positive fourth-quarter earnings, remains receptive to new share issuance, says Daniel Arnold, another analyst at Sandler O'Neill who covers small-cap banks. While some banks whose shares have outperformed the market are ready to raise capital, shares of a lot of small-cap names have still lagged. That's holding some institutions back from selling shares, says Arnold; they're hesitant to raise capital at current stock valuations because doing so would dilute their earnings per share.