I have been following the banks and other financial stocks for more than 45 years.
While getting my MBA in finance from Wharton I was a "Nader Raider" and I co-authored the book "Citibank" with Ralph Nader and The Center for the Study of Responsive Law. Over the years the book was used as a textbook in a number of college banking courses.
When I entered the workplace I was a bank and thrift analyst at Putnam Management in Boston. Near the end of the 1970s Institutional Investor Magazine voted me the No. 1 buy-side analyst in financials.
As I started out my career, the banking industry was undergoing a metamorphosis from stodgy to progressive. Bricks-and-mortar, traditional banking was undergoing systemic change. ATMs were introduced, negotiable CDs provided balance sheet growth and regional banks and thrifts in California, Texas, Florida and in other rapidly expanding states were considered growth stocks and were accorded high valuations.
But I also saw the downs: The failure of Charlie Knapp's Financial Corp. of America, which I was indirectly responsible for exposing through my friend Dan Dorfman at CNBC; the savings and loans crisis in the 1980s and 1990s; and, of course, the mortgage crisis in 2008-2009, which effectively bankrupted nearly all the world's largest financial institutions.
In reaction to The Great Recession of 2008-2009, bank regulation became significantly more stringent, which was in marked contrast to the unregulated and highly leveraged past. Fines and rising compliance and legal costs ramped up over the last decade, serving to restrict banking industry profitability. The days of leveraging capital to the extremes was over, and balance sheets contracted. These factors served to reduce return on invested capital as well as profitability over the last decade.
The Case for Bank Stocks
- The banking industry is asset-sensitive, benefiting from a backdrop of rising rates and a widening yield curve
- Abating cost pressures, an expansion in net interest margin and income coupled with aggressive share buyback programs augur well for better-than-anticipated earnings growth in the years ahead
- Future industry share price performance will also benefit from the currently low valuation base
I expect to hold on to bank stocks for an extended period of time, measured in years and not in weeks or months. To me, bank stocks are the best long hedge when viewed and measured against a baseline expectation of modest and below-consensus global economic growth. On the other hand, if you possess a more optimistic growth assumption, an ultimate resolution of the Chinese trade issue, a less-protectionist U.S. policy, slowly rising inflation and a steady Real GDP growth of about 2% annually, I am convinced that the relative outperformance from a low valuation base may dramatically surprise to the upside in the years ahead.
To me, the uninspiring revenue and profit expectations for the second half of 2018 (third and fourth quarters) has provided an opportunity to buy bank stocks before the market realizes that a sustainable period of improving profit and ROI returns lies ahead.
The features thus far seen in the fourth quarter have been:
- Modest credit demand growth
- A slower rate of growth in deposits than the rate of growth in commercial and industrial (C&I) loans
- Short-term interest rates remain low, net interest margins and income have been stable
- Mortgage originations and refinancings continue weak
- Good credit quality metrics
- Aggressive share buybacks have been maintained
- Updating for December capital markets activity, trading and investment banking will be much lower
Citigroup's Q4 Results Reinforce the Notion That Bank Stocks Represent Value at Current Levels
Citigroup (C) provided a glimpse of what to look for in the other reports of the major money center banks this week.
The backdrop was rotten. Importantly, the capital markets shut down in late November and throughout the month of December, dramatically and adversely impacting trading revenues. As well, the yield curve flattened and bond yields fell.
Despite that, Citigroup recorded a beat to earnings, though, not surprisingly, revenue was under consensus expectations. (I commented on the results in my first post of the day.)
Citi generated more than $4 billion in profits, demonstrated good expense control, a nearly 11% return on tangible net worth and projected a 12% goal for 2019, and, most importantly, exhibited eight straight quarter of positive operating leverage and improving efficiencies. All the while, the bank repurchased nearly 75 million shares of its own stock.
Given the December freeze-up in trading and based on my contacts and analysis, I would not be surprised to see JPMorgan Chase (JPM) , given a business mix that is skewed toward trading, to report slightly disappointing core results here on Tuesday morning in absolute terms and relative to Citigroup. The same observation applies to Goldman Sachs (GS) in light of its similar business profile to JPM.
January's operating conditions should bring improved core results for those banks, which have a heavy trading exposure/involvement. So, the markets may see through some possible disappointments.
But Sunny Skies Lie AheadThe banking industry has come out of the last decade materially safer and stronger as measured by excess capital positions than at almost any time in history.
Fourth-quarter bank industry results likely will be in line with consensus forecasts, with little meaningful deviation from EPS expectations and, considering the awful backdrop of trading, interest rates and the yield curve, that's a good starting point for better share price performance.
A number of secular factors, clearly not appreciated by many investors, will likely buoy future bank industry profitability and share prices in the years ahead:
1. Europe's banking industry financial and operating woes will continue to inure to the benefit of the large U.S. money center banks, which will continue to be opportunistic, stampeding toward gains in corporate and retail market share as well as taking share in global fixed-income trading.
2. Loan demand should begin trending better as corporate profit growth moderates in 2019-2020 and credit markets tighten as companies will begin to rely again on large banks to fund growth.
3. With a pivot in global monetary policy from expansion to contraction, interest rates are likely headed higher in the fullness of time and the yield curve should be widening.
4. Deposit bases have expanded materially over the last decade, in large measure because of Fed-sanctioned big bank acquisitions following The Great Recession of 2008-2009 (this is underappreciated by the markets).
5. The banking industry is asset-sensitive, so the inevitable rise in interest rates on top of the aforementioned expanding deposit bases will be a big profit generator and fuel for growth.
6. I expect strong absolute and superior relative EPS progress compared to the S&P Index beginning in the current quarter (first quarter of 2019).
7. The banking industry is vastly overcapitalized, and Comprehensive Capital Analysis and Review (CCAR) results will continue to allow a return of capital in the form of higher dividends and large buybacks that will support share prices and EPS growth for years.
8. The pendulum back toward easing bank regulations markedly will reduce the pressure on costs and will lead to easy profit comparisons in 2019 through 2024.
9. Bank price-earnings multiples begin at a low base; valuation expansion is likely in the years ahead.
For the reasons mentioned above, which start at low valuations (absolute and relative), bank stocks may represent the single most attractive industry group in the S&P Index.
In concert with a sharp falloff in bank stock prices in the fourth quarter of 2018, I recently moved into a large investment position in banks, which now represent by far my most sizable industry exposure on the long side.
I anticipate holding bank stocks for an extended period of time, measured in years not weeks/months.
(This commentary originally appeared on Real Money Pro on Jan 15. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)