With the U.S. economy set to contract severely this quarter amid the COVID-19 lockdown, bank stocks as a group have fallen much more than the broader market. But it isn’t too early for investors to think about opportunities in strong players with competitive advantages that may be overly discounted.
On April 7, David Konrad, a managing director and analyst at D.A. Davidson, and Ian Lapey, a portfolio manager at Gabelli, discussed in interviews seven bank stocks that may turn out to be good investments.
You are probably familiar with this famous quote from Berkshire Hathaway
CEO Warren Buffett, but a reminder is in order: “You want to be greedy when others are fearful. You want to be fearful when others are greedy.”
It sounds simple, but human nature makes it difficult for most investors to consider buying stocks during a time of panic. Buffett said that during an interview in October 2008, and went on to make a lot of money from his timely investments in Goldman Sachs
in September 2008 and Bank of America
in September 2011. Berkshire’s money was important to both companies when the investments were made, and Buffett’s scored lucrative returns.
Berkshire is now Bank of America’s largest stockholder, with 10.6% of common share outstanding, while it is Goldman’s fourth-largest shareholder, with a 3.5% stake, according to FactSet.
The seven banks
Analysts expect the largest U.S. banks to remain profitable on a full-year basis in 2020 and 2021. However, this is the point in an economic downturn when lenders must increase their quarterly provisions for loan loss reserves by large amounts, and all of that comes out of earnings.
When banks’ earnings are predictable, they can be valued on a price-to-earnings basis. But during a period of economic turmoil, investors and analysts focus on price-to-tangible-book values. Here they are for the seven companies Konrad and Lapey discussed:
|Bank||Price/tangible book value – April 7||Price/tangible book value – Jan. 31||Share-price decline – Jan. 31 through April 7|
|J.P. Morgan Chase & Co.||1.5||2.2||-32%|
|Bank of America Corp.||1.1||1.7||-35%|
|CIT Group Inc.||0.8||0.8||-4%|
|Bank of New York Mellon Corp.||1.8||2.3||-21%|
|State Street Corp.||1.7||2.3||-27%|
You may have to scroll the table to see all the data.
The price-to-tangible-book valuations have declined for all except for CIT Group
To put the share-price declines since Jan. 31 into perspective, the S&P 500 Index
fell 18% during the same period.
Price-to-tangible-book valuations are usually higher for the two trust/custody giants, Bank of New York Mellon
and State Street
because both have relatively low exposure to loan losses. Loans made up 14% of Bank of New York Mellon’s total assets as of Dec. 31, while loans comprised 11% of State Street’s assets.
The ‘safest’ bet
Lapey, who manages the Gabelli Global Financial Services Fund
called Bank of New York Mellon and State Street the “safest” bank stocks to buy now, because “they are really asset managers and custodians, rather than banks.” Even through the Federal Reserve’s “severely adverse scenario,” used for the regulator’s stress tests of the largest U.S. banks in June 2019, both companies ”were actually profitable,” he said.
The Fed’s severe scenario included U.S. unemployment reaching 10%, a 50% decline for stocks and an 8% GDP contraction.
“They are the plumbing of the financial system, and so far it has worked well” through the coronavirus downturn, Lapey said.
If Bank of New York Mellon and State Street can be profitable in 2020, “they should trade at higher multiples than they have been trading at over the past few years,” he said.
“It is an industry with massive barriers to entry,” Lapey said. “And their tech spending has really paid off. Certainly those companies shouldn’t have to raise capital.”
Citi and CIT: Dogs no more
The fear of having to raise capital, which would dilute the ownership percentage of current shareholders, is one reason bank stocks have fared so much worse than the broader market during this downturn.
In the 2008 credit crisis and its aftermath in 2009, the U.S. Treasury invested a total of $49 billion in Citigroup
The government’s preferred shares were eventually converted to common shares and sold to the public, for a profit. But that level of dilution meant that pre-crisis common shareholders’ ownership of the company was nearly wiped out — if they continued to hold the shares, they never recovered. The stock’s total return for 15 years through April 7 was minus 88%, according to FactSet. Among the 10 largest U.S. banks, the only other one with a negative 15-year return has been Bank of America
Long memories are why Citigroup trades at only 0.6 times tangible book value — the lowest valuation among the seven. But Lapey believes Citi is now “in a fine position.”
He said that with a strong capital position and much improved management, the bank is unlikely to have to raise additional capital during the coronavirus downturn. “And if they do that, they will not be trading at a 40% discount to tangible book value in three years,” he said.
Konrad rates Citigroup a “buy” and said the company’s “global footprint” might be an advantage, especially because “the COVID-19 curve is less in Asia than it is in the U.S.” In a report April 2, Konrad called Citi his “top pick,” citing the low valuation and excellent credit risk management in recent years.
CIT Group went bankrupt in 2009, in part because its business model relied on the commercial paper market to fund its loans. The unsecured overnight paper market dried up in 2008, causing a liquidity crisis for the lender. But CIT is now a bank holding company with deposits from its online bank providing 82% of funding, according to Lapey.
“The underlying lending business they do is mostly senior-secured, first-lien. So they are in a great position to go into situations where a borrower needs liquidity, and they can charge for it,” he said.
Lapey emphasized the importance of underwriting, especially now, saying lenders needed to make sure they would be compensated for increasing risk by charging higher interest rates if they “waived loan covenants” or gave other credit breaks to borrowers.
Morgan Stanley — a changed business model
and Citi have historically been risk-off,” Konrad said, meaning that at any sign of economic distress, investors steer clear of both stocks.
But he went on to say that Morgan Stanley has “changed its business model and reduced its trading exposure.”
He then dug further into the Fed’s stress testing, saying Morgan Stanley took issue with the regulator’s assumptions about how much earnings would decline in the “severely adverse scenario” in last year’s stress tests. When the stock market declines, an asset manager’s revenue declines because advisory fees are a percentage of assets under management.
But Morgan Stanley CEO James Gorman said during the company’s earnings call July 18 that the Fed’s assumptions apparently didn’t include a corresponding decline in expenses — a decline in financial advisers’ fees meant the company would be paying them less. He said the company was “highly engaged” in discussing this with Federal Reserve officials, according to a transcript provided by FactSet.
“So that is a long-term discussion, but now we are living in real life. If their costs are lower than expected, it could free up some capital for them if the Fed changes their view” during this year’s stress tests, Konrad said.
Konrad has a neutral rating on Morgan Stanley, but said the stock may eventually trade higher to tangible book value, relative to peers, if the Fed changes its view.
Mobile banking and market share
Konrad rates Bank of America
a “buy,” and has a neutral rating on J.P. Morgan Chase
When asked which banks might emerge from the coronavirus in excellent competitive positions, he said both ”are well ahead of the game in terms of mobile banking,” and that “there could be some market-share shifts because for their already seasoned products.”
J.P. Morgan has pretty much been the gold standard for large U.S. banks following the 2008-09 crisis. Konrad expects the bank to outperform peers during this downturn, as they did the last one, and he wrote in his April 2 note that he expected J.P. Morgan “to play one of the largest roles in the industry in terms of being part of the solution with both consumers but also through liquidity issues with corporations.”
That said, Konrad thinks the quality gap between J.P. Morgan and other large U.S. banks has narrowed, and that since J.P. Morgan’s shares already trade at a high premium to other universal banks, they “don’t have as much upside in our valuation” as Bank of America’s shares.