After six years of zero percent interest rates, the Federal Reserve finally hiked the Federal Funds rate by 25 basis points. This puts the new Fed Funds range at 0.25%-0.5% from 0%-0.25%.
While a 2015 hike has been anticipated for several quarters, the Fed certainly pushed its 2015 target to the limit with the December hike. This hesitation on behalf of the Fed is a big reason that many analysts think it will be a while before we see another hike.
Nevertheless, with a higher interest rate comes a better outlook for financials and bank stocks. It means higher net interest margins and bigger profits in a sector of the market (financials) that has been greatly undervalued since the recession in 2009.
To get an idea of what higher interest rates mean for bank stocks, Bank of America (BAC) recently explained that a 100-basis-point rise in interest rates could create an extra $4.5 billion of net interest income for the bank.
With a 25 basis point rise, BAC could still see a significant boost to its top and bottom line for 2016, as could many financial companies. This in turn means there are many bank stocks that investors should eye, and potentially own right now.
Let’s look at seven bank stocks that investors should consider for 2016.
Bank Stocks to Buy: Bank of America (BAC)
Speaking of BofA, BAC is one the most attractive bank stocks following the interest rate bump. Based on its own formula, BAC should earn an extra $1 billion in 2016 from the Fed’s interest rate hike. Not to mention, BAC’s profit could be greater if the Fed ups the rate, or if the Funds rate tracks closer to 0.5%.
With that said, BAC wasted no time in solidifying these higher profits, upping its prime rate by 25 basis points after the Fed’s decision. This means that BAC will see higher profits after the Fed’s decision.
However, what makes BAC so appealing headed into 2016 is both its valuation and the catalyst that surrounds its capital-return plan. Back in March, the stress tests found that BAC had deficiencies in its internal controls. However, just recently BAC received clearance from the Fed for its capital return plan, which should help BAC stock start trading towards its book value per share of $22.41.
BAC stock is one of the few financials trading below its book value per share. Fact is that BAC’s book value per share is only going to rise with interest rates, and with top research firms like RBC predicting big upside with a price target of $20, and its capital return plan likely to be approved, BAC looks like one of the superior investment ideas stemming from the Fed’s decision.
Bank Stocks to Buy: PNC Financial Services (PNC)
PNC Financial Services (PNC) is one of the top regional banks in the country. It has a leading presence in many of the top financial regions of the country, and is not exposed to global risks — like falling interest rates in Europe — like larger money center banks are.
Just recently, PNC’s CEO Bill Demchak explained that the Fed rate “drops money” to the company’s bottom line, and that PNC has marketing initiatives in place to attract customers. He added that lower energy prices should have an effect on consumer spending. Therefore, PNC is expecting continued strength looking ahead, or at least in the regions in which it operates.
Overall, Zacks Investment Research foresees a double-digit upside with a price target of $104. PNC currently trades at $96. Personally, I think $104 is a fair target for PNC. The stock trades significantly above its $81.37 book value per share.
However, PNC has thrived in just about every lending and interest-income related metric that exists among financial companies. Thus, PNC is well worth the premium, and while a low-double-digit upside may not seem that appealing, it is performance that will more-than-likely outperform the broader market.
This makes PNC a bank stock to buy.
Bank Stocks to Buy: Citigroup (C)
Citigroup (C) is a massive, global bank with very few growth opportunities ahead. Like BAC, C is a value story, a company whose goal is to downsize, become more efficient and create shareholder value by driving profits higher.
Of course, higher interest rates help achieve this goal of driving profits higher.
The higher rate is especially important for C due to a large percentage of its deposits being on the short end of the yield curve, closer to 0.5% of the Fed’s interest rate range. Much like Citigroup’s peers, the bank wasted no time taking advantage of the Fed’s interest rate decision, increasing its Prime rate to 3.5%, which means higher interest income from small business loans and credit cards, two big areas of C’s business.
That said, higher interest rates are clearly a catalyst for C, like all financials. However, the bigger catalyst for C in 2016 is the effect of the bank’s cost-cutting and the continued decline of its efficiency ratio. Over the last three years, Citi’s efficiency ratio has hovered around 57%, a big improvement from the 60%-plus in the few years following the housing crisis.
However, many analysts now foresee a big jump to 53% due to ongoing cost cuts and higher income.
Therefore, 2016 is setting up to be a big year for Citi’s bottom line, and with the stock about 30% lower than its book value per share, investors should expect C to be one of the biggest beneficiaries of higher interest rates.
Bank Stocks to Buy: Bank of Montreal (BMO)
Bank of Montreal (BMO) is an interesting bank in a rising interest rate environment for several reasons.
First, BMO stock is down 20% this year, significantly underperforming the broader financial sector. Second, BMO pays a dividend yield of 4.3%, among the highest yields in the financial world. And lastly, BMO’s biggest operating segment is U.S. Personal and Commercial Banking, a division that is directly tied to net interest for revenue and profits.
During BMO’s last fiscal year, net income was up only 2% to $4.4 billion, and management blamed low rates as a key reason for the company’s lack of earnings growth over the last year.
With the majority of BMO’s business tied to personal and commercial loans, and also deposits, it is a company that could see significant top- and bottom-line growth.
Bank Stocks to Buy: Morgan Stanley (MS)
Morgan Stanley (MS) is not a company that comes to mind when investors think of beneficiaries in a higher-interest-rate environment. MS is known for its massive brokerage services, but over the last few years the company has become more of a wealth manager.
This transition gives MS the opportunity to collect fees at the short end (0.25%) of the yield curve, thereby boosting its profits by a quite meaningful margin. With that said, it has been a rough year for MS, losing 16% of its value due to higher expenses and ongoing struggles in its fixed-income business.
However, higher interest rates along with MS eliminating 25% of its fixed-income trading staff sets the stage for 2016 to create higher profits and lower expenses.
In other words, what caused stock losses in 2015 could be catalysts in 2016 for MS.
Bank Stocks to Buy: Wells Fargo (WFC)
Over the last few years, Wells Fargo (WFC) has been top tier when it comes to bank stocks, but strangely, there is more uncertainty surrounding WFC with higher interest rates than at any point over the last three years.
Specifically, WFC is the king of mortgage originations, and yes, long-term loans like mortgages are among the financial products that gain most from higher interest rates. However, new mortgage originations have been quite fickle as of late, with WFC posting a quarter-over-quarter decline during its last three month period.
In other words, WFC may earn more income from higher interest rates, but that hike could be countered with declines in mortgage originations. This makes WFC more of a high-risk bank stock investment for 2016 … but also a high-reward investment if originations move in the right direction.
Bank Stocks to Buy: U.S. Bancorp (USB)
Last but certainly not least, U.S. Bancorp (USB).
Given the vast supply of bank stocks and the fact that not all banks are created equal, most investors have a strategy headed into 2016 to profit most from higher interest rates.
As previously explained, I like regional banks that lack exposure in struggling European markets and are dominant in thriving areas of the country. Therefore, I really like USB. In fact, it might be my top bank stock idea for 2016.
USB has remained a consistent dividend income investment and a company that keeps giving back to shareholders in the form of share repurchases. Furthermore, USB is a top Warren Buffett stock, with an almost unprecedented efficiency ratio of under 54% — lower than even the mortgage giant WFC.
With USB sure to profit from higher interest rates on both ends of the curve and the company’s CEO already talking about job cuts to boost profits, investors can rest assure that USB will once more be pumping dividends, buying back stock and trading higher in 2016.
As of this writing, Brian Nichols owned shares of BAC and USB.
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