What’s your take on bank stocks? Almost everyone seems to have an opinion.
Dick Bove, Senior Vice President of Equity Research at Rochdale Securities, believes bank stocks are oversold despite a recent 30%-40% bounce. Bove’s rationale is simple: Banks are being valued at a serious discount to book value when they really should be getting a premium, given the toxic assets that were on balance sheets in the past have been replaced by cash. And he thinks this will be revealed to the world Thursday in the Federal Reserve stress tests.
It’s a great theory, but I wouldn’t start planning the banking parade just yet. Investor confidence still is very tepid. Let’s examine why:
Evaluating bank stocks is a task unlike any other because the valuation metrics are completely different. For example, the Basel III regulations being adopted over the next few years call for a minimum Tier 1 capital ratio of 7% by January 2019. Including the maximum buffers suggested by the Basel Committee on Banking Supervision, the biggest banks in the U.S. could face a minimum of 12.5%. This means that their Tier 1 capital (defined as equity plus reserves minus intangible assets) would have to be at least 12.5% of adjusted assets (defined as total assets minus intangible assets), or what is often referred to as risk-weighted assets.
Wells Fargo‘s (NYSE:WFC) Tier 1 capital ratio as of the fourth quarter 2011 is 11.33%, below this potential hurdle, as is JPMorgan Chase (NYSE:JPM) at 12.3%. Of the five biggest U.S. banks, only Citigroup (NYSE:C), at 13.6%, is above the potential bugaboo.
The trick for investors is determining how likely it is that these additional buffers will come into play. Dick Bove clearly feels they won’t and is betting 7% is more than adequate. How can he be so sure?
As a result of the Tier 1 requirements, much of the discussion regarding banks has to do with book value and dividends. The average annual dividend yield for U.S. banks using the KBW Bank Index as a proxy is 3%. According to American Banker, bank holding company dividends are currently about one-third what they were prior to the financial crisis in 2008.
It’s no wonder, then, why bank stocks have been punished so severely. They’re not paying out enough cash to investors, and as a result, those investors are looking elsewhere for their income fix. The current S&P 500 dividend yield of 1.93% is at or near an all-time low, and yet it’s still higher than what you can get at some of those “too big to fail” establishments.
The bank bulls, like Bove, are betting heavily that a clean bill of health March 15 from the Federal Reserve stress tests will unleash a powerful wave of dividend increases and share repurchase announcements that will bring back the dearly departed income investors.
How Healthy Are the Banks?
The problem with this rationale is that investors know better. These tests are nothing but the Federal Reserve putting on a show for taxpayers. Regardless of whether banks are permitted to increase their payouts to shareholders moving forward, it still doesn’t tell us how solvent these 19 banks really are.
Bove assures us they’ve replaced the bad assets with cash, but have you looked at a balance sheet lately? I defy you to explain each line on both sides of the ledger. I can’t. And even if you could, how would you know if the assets haven’t been manipulated? There is no simple way of determining whether a bank’s loans and other assets are worth the paper they’re written on.
So far, nine banks have failed in the first 70 days in the year. That projects to 47 banks shutting their doors, the lowest level since 2008. Some in the financial world would like us to celebrate the wonderful news, employing a glass-half-full mentality. But putting your skeptical cap on for a moment, you realize that it’s still way too many.
If banks truly are building capital structures deemed impenetrable based on Tier 1 capital and the other Basel III measures, then why are we still seeing bank failures? The construction of these fortresses is built on quicksand. With few exceptions, the largest of the banks solidified book value by seriously diluting existing shareholders.
Since 2007, Morgan Stanley (NYSE:MS) has increased its total share count by 67%. Once it passes the stress test next week, it will announce that it’s upping its quarterly dividend and buying back stock, taking money out of one pocket (issuing shares) and putting it back in another (share repurchases) — all the while proclaiming that it’s delivering value to shareholders.
However, the biggest problem isn’t whether shareholders are getting a raw deal — which they are — but rather they have no way of knowing whether any of this bunkering will do any good should another economic firestorm hit our shores.
“The banking industry in the United States has more common equity as a percentage of assets than at any time since 1938.” That’s according to Dick Bove, who believes stocks like Morgan Stanley are trading at ridiculously low price-to-book ratios.
This isn’t a new argument. The Wall Street Journal ran an article in June 2011 quoting BMO Capital Markets analyst Justin Hoogendoorn, suggesting that bank stock valuations will remain low until regulators set the permanent playing field under which bankers can run their businesses.
Until then, just because the banks pass the stress tests and are able to deploy capital, it doesn’t mean the game is on — no matter what Dick Bove tells you.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.