We have been bullish on banks and have liked and recommended State Street (STT) a number of times over the past few years. As we discuss below, the stock is a play on the recovering global capital markets and on higher interest rates. The stock has done very well since we first began discussing it. However, after its poor start to 2014, we think it is poised for its next meaningful move higher.
Today we'll address State Street as well as its two closest peers, Northern Trust (NTRS) and Bank of New York (BK). We think that, when compared with these franchises, State Street offers as good or better prospects and a lower valuation level.
Stacked against Northern Trust, we believe State Street offers comparable earnings prospects. Northern Trust relies more on its high-margin wealth management unit to drive results, whereas State Street sees its fundamentals driven by its industry-leading equity custody platform to produce similar top- and bottom-line performance. Furthermore, for those comparable growth prospects, one can buy State Street for 13x 2014 earnings estimates vs. 18.1x for Northern Trust.
When compared with the Bank of New York, State Street offers a trifecta of benefits. State Street should have a higher growth rate due to Bank of New York's heavy focus on the slower-growing fixed-income custody and money-market-related businesses. State Street is also considered a much better-managed and shareholder-focused franchise than is Bank of New York. Lastly, State Street shares are also trading at a lower valuation: Its 13x multiple compares with 13.9x for Bank of New York.
We think all of these custody- and asset-management-focused franchises will do well with better capital-market activities and higher interest rates. In particular, the record low fed funds rate has meaningfully impacted profitability and earnings growth. All of the firms will materially benefit when the fed funds rate reverses. We just prefer to own State Street.
Note that State Street has lagged the other two companies during the current quarter. Management gave muted guidance at its recent investor day, as well, predicting lower revenue on weaker foreign-exchange trading, slower capital markets activity and negative emerging markets trends. Also disappointing were the higher-than-consensus expected compliance costs of $30 million to $40 million annually, and greater-than-expected preferred-share dilution -- which should cost the company $0.05 per share annually. Analysts were upset with all this, and the stock has been swooning ever since.
However, we believe this disappointment puts management under pressure to produce better results sooner rather than later, and we believe investors should step up and buy State Street shares at current levels. The recent underperformance has given investors an attractive entry point, and it sets the stage for the company to outperform its peers from here on out.
In short, we like State Street at the current price, if you own it, stay with it. We also believe now would be a good time to take profits in Northern Trust and Bank of New York -- and to roll the proceeds into State Street.