A Pair of Names Worth Banking On

 | Oct 11, 2012 | 11:30 AM EDT
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My late father had a lot of folksy sayings when I was growing up, including this favorite: "Life is like a pendulum. It swings too far to the left and it swings too far to the right, but it always ends up eventually in the middle." My dad also was a banker for 35 years -- back when banking was a noble, if boring, profession. Banks collected deposits and made loans and did little besides that. Bank stocks were mundane but consistent performers that paid a nice dividend and were frequently found in "widows and orphans" portfolios. In short, they functioned like utility stocks do today. Times certainly have changed.

I was reminded of this the other day when I took a look at the Financial Select Sector SPDR (XLF) over the past five years and compared it to the Utilities Select Sector SPDR (XLU) over the same time period (see the chart below). Bank stocks cratered during the financial crisis and have roughly followed the performance of the utility index since the nadir of March 2009. Overall, the utility index has outperformed the financial services index by some 50% over the last half decade.

Source: Yahoo! Finance

However, over the next five years I would not be surprised to see the total flipside for these indices. Utility valuations are stretched, with stalwarts such as Consolidated Edison (ED) selling at 16x earnings and at the top of its five-year valuation ranges (based on P/B, P/CF, P/E and P/S). Bank stocks, on the other hand, are going for 10x-11x forward earnings and have better long-term growth prospects. Yields of 2% to 3% may not look enticing to income investors right now, but those are at very low payout ratios. As payout ratios drift back to the traditional 40% to 50% levels, yields on many bank stocks will be in the 3.5% to 4.5% range at current prices, which is comparable to utilities.

In addition, housing is the biggest source of collateral for bank loans, so as the housing market continues to improve, so should bank earnings. Last, the Federal Reserve's QE efforts will eventually diminish and the yield curve will steepen. This will also benefit banks' margins. So  here are two of the largest residential lenders that I think will do very well over the next five years.

Wells Fargo (WFC) is an over $200 billion market capitalization bank with over 250,000 employees. It is the largest residential lender in the country.

Three reasons to pick up Wells Fargo at $35 a share:

  1. The stock yields 2.5% at just under a 30% payout ratio. The company also has quadrupled its dividend payouts since emerging from the financial crisis.
  2. It has slightly beat earnings estimates the last three quarters and I would look for that to continue when the company reports earnings tomorrow.
  3. WFC is selling for less than 10x forward earnings and has a very reasonable five-year projected PEG (1.24) for a dividend payer.

U.S. Bancorp (USB) is a large Midwest based lender that currently is the third biggest residential lender in the U.S.

Three reasons USB is a good long-term value for income investors at under $35 a share:

  1. USB yields 2.2%, has a payout ratio below 30% and has almost quadrupled its payout since 2009.
  2. The stock's consensus earnings estimates have ticked up nicely over the past 90 days for fiscal 2012 and fiscal 2013. The company has also slightly beat earnings estimates each of the last six quarters.
  3. The company sports an A+ rated balance sheet, sells at 11.3x forward earnings and Standard & Poor's rates its fundamentals (credit quality, loan growth, etc.) as the best among major banks.

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