It was a tough week for bank investors, as an unexpected Brexit vote out of the U.K. hit bank stocks particularly hard. However, once the Brexit dust settles in the market, Bank of America Corp (BAC) and Citigroup Inc (C) will be excellent buys.
Before both bank stocks were down more than 7% on Friday, both stocks were trading higher in Thursday’s after-hours session following the results of the first round of the Federal Reserve Stress test.
Most traders probably saw headlines that all 33 banks tested this year “passed” the test, and May have completely dismissed the results as meaningless.
In reality, the quantitative results of the stress test tell an important story about the relative strengths of the banks’ balance sheets and how much they have improved in the last year.
First of all, it’s important for risk-adverse investors to understand just how extreme the Federal Reserve’s “severely adverse” test scenario is. This scenario tests banks’ Tier 1 common equity levels under the following conditions:
-Severe global recession
-U.S. unemployment doubles to 10%
-Negative yields for short-term U.S. Treasuries
-6.25% decline in U.S. GDP
-50% decline in stock prices
-Stock market volatility in-line with 2008 levels
-Housing prices drop 25%
-Commercial real estate prices fall 30%
If a bank can survive that mess without needing outside capital, investors can sleep well at night.
Not only did Citigroup and BAC both exceed the minimum Tier 1 common equity ratio threshold of 4.5%, they both passed with flying colors. BAC’s minimum ratio came in at 8.1% and Citigroup’s ratio came in at 9.2%, well above the average ratio of 8.3%.
Both banks passed the test by a wide margin, and both dramatically improved their ratios since last year’s test. While the average ratio of the banks tested climbed just 0.1% since last year, BAC and Citigroup’s ratios both climbed 1.0%.
BAC and Citigroup Stock Offer Tremendous Value
The strong numbers out of both banks are the culmination of years of work since the Financial Crisis to eliminate risky investments, boost capital levels and shore up balance sheets. Yet, despite the fact that the banks’ businesses are as streamlined as ever, the stocks trade at a tremendous discount to historical multiples.
Not only do both stocks have a forward price-to-earnings ratio under 9, they both trade at a significant discount to tangible book value. Prior to the financial crisis, the price to tangible book value of both stocks ranged mostly between 2.5 and 4.5. Both now rest at 0.56. In other words, both stocks remain valued at significantly less than the total cumulative value of the assets they own.
The stress test results were wonderful news for both banks, but Friday’s headlines and trading action were dominated by the Brexit vote. With as much cushion as their stress tests indicated, it wouldn’t be surprising to see both banks are approved for aggressive capital return programs when the Comprehensive Capital Analysis and Review portion of the stress test is released on June 29.
Regardless of the CCAR outcome, BAC and Citigroup are two bank stocks that have streamlined their businesses ahead of a potential long-term interest-rate tightening cycle.
Both stocks have less risk today than they have possibly in their entire history and both were cheap prior to the Brexit sell-off … now they are even cheaper. Opportunistic investors should wait until the market volatility dies down, and then scoop up these rare long-term value plays.
As of this writing, Wayne Duggan was long BAC and C.