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4 Bank Stocks to Sell and 4 Cash-Generating Alternatives to Buy

Alt-financials and emerging fintechs are majorly disrupting traditional bank stocks

bank stocks - 4 Bank Stocks to Sell and 4 Cash-Generating Alternatives to Buy

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I started my professional career in banking. First I was with Merrill Lynch International Bank, then with the boutique Mark Twain Bank — now part of U.S. Bancorp (NYSE:USB) — and onto Investec.

The key to banking is to gather deposits, seek out opportunities to make loans, cut costs and maximize fee income  — and make absolutely sure that you know how the bank will get paid interest and principal.

There are specific metrics to measure how a bank is faring. Banks report deposit and loan growth, of course. And they report profit margins. These include the net interest margin (NIM) which is the difference between what a bank pays for deposits and what it earns in loans. And for cost controls there’s the efficiency ratio which measures the percentage of what it costs a bank to earn each dollar in revenue. The lower the ratio, the lower the costs and the higher the profit margins.

U.S. bank stocks have been lagging for some time. First, interest rates have remained quite low as the Federal Reserve and its Open Market Committee (FOMC) has been buying bonds to drive yields lower. With rates so low, NIM was also kept very low, leaving little profitability for banks in their traditional job of attracting deposits and making loans.

Then, in response to that same mess, banks were burdened with a myriad of capital requirements, which ultimately drove up costs. These regulations led efficiency ratios way up and in turn drove down profit. The result is that over the past ten years, bank stocks as tracked by the KBW Bank Index have woefully trailed the return of the general S&P 500 by 83.4%.

Source: Chart by Bloomberg

But in the fourth quarter of 2019 banks stocks got some investor interest as they were pitched as value stocks. And the KBW Bank Index got some life in the process.

Source: Chart by Bloomberg

However, we’ve now gotten a collection of quarterly reports from the big banks in the U.S. and it is not good. NIM is down — made worse with the FOMC’s resumption of quantitative easing (QE), bond buying and lower targeted interest rates. And efficiency ratios are getting worse as promised regulatory relief is not panning out.

Meanwhile, alternatives to banks have been thriving without the same regulations. The alt-financials are doing much better and their shareholders are being better rewarded.

Last year I dumped the banks inside my Profitable Investing because of all the false starts for NIM and efficiencies. And with banks getting positive news of recent, I am arguing again that U.S. bank stocks should not be bought — and should be sold right now.

Bank Stocks to Sell: Wells Fargo (WFC)

Source: Chart by Bloomberg

Let’s start with Wells Fargo (NYSE:WFC). Now, forget about the regulatory purgatory that the bank finds itself in after years of customer abuse and the millions of dollars in fines announced this week. And forget about the restrictions on the bank’s size and growth resulting from the history of fraud.

Wells Fargo has other core issues.

Deposits are barely moving with the trailing year seeing anemic growth of 2.8%. But what really stings is that loan growth is only 1.7% — in an economy which remains robust. Net interest margin (NIM) is only 2.8%

Source: Chart by Bloomberg

That NIM is down sharply and reflects the challenges given the changes in short-term U.S. interest rates. But what is more disturbing is the cost of revenue, with the efficiency ratio at a whopping 78.1% — which to remind you means that it takes 78.1 cents to make $1 in revenue. That’s not a way to be profitable for shareholders.

The return on assets is on par with other banks at 1%, but the return on equity is weak at 10.6%. The one grace is that non-performing assets (NPAs) are quite low at 0.3% of total assets and 0.6% of total loans.

Shareholders have been getting what they deserve if they still own this stock. Over the trailing five years, WFC has lost 9.5% in price and managed to return on 5.7%. This compares to the S&P 500’s return of 79.5% and the KBW Bank Index return of 79.7%.

Bank of America (BAC)

Source: Chart by Bloomberg

Next up is Bank of America (NYSE:BAC). This bank is not much better even without the fraud issues of Wells Fargo. NIM continues to fall over the past two quarters, reversing modest gains, and is down to 2.5%. And while the efficiency ratio is much better than in the prior quarter, at 59% it is still very high.

Source: Chart by Bloomberg

Return on assets is again on par at 1.1%, but not impressive. And the return on equity is low at a mere 10.7%. NPA represent 0.2% of total assets and 0.4% of total loans, so risks are muted. But deposits aren’t moving up much at a rate of 3.9%. Loan growth is low at 3.7%.

What is interesting is that BAC has been able to both outpace the S&P 500 and the KBW Bank Index in total return over the trailing five years.

Despite the improved stock price, this brings trouble for investors. This is because the market has really only bolstered the valuation of the stock, rather than the company bolstering its underlying book and sales numbers.

Source: Chart by Bloomberg

Regions Financial (RF)

Source: Chart by Bloomberg

Regions Financial (NYSE:RF) was a favored bank of mine back in 2018. The U.S.-centric bank has regional presences in some of the best parts of the country. And the U.S. economy was set to improve its financial performances. Indeed, if you look at its 2018 quarterly reports, you’ll see some signs of improving NIM and efficiency ratios which came from better management.

But that’s now reversed, with NIM dropping to 3.4% and the efficiency ratio climbing to 60.1%.

But what really looks bad for Regions is in the core business of being a bank. Deposits are up at 3.2%, but loans — the core way that banks make money — have only managed to edge up by 0.2%. That’s terrible. And while NPA are low (no wonder given the low growth rate) the resulting return on assets is only 1.3% with return on equity only managing to reach 10.3%.

That said, somehow folks have been willing to pay up for the bank’s shares with the past five years seeing a return of 105.3% compared to the S&P 500 and KBW Bank indices generating returns in the 79% range.

But don’t get carried away. Unlike how enthusiasm in BAC is pushing up price-to-book and price-to-sales ratios, with Regions, the stock price has come more in line with weaker valuation measures. The price-to-book ratio is sitting just above 1 and the price-to-sales ratio sits at 2.4 times.

Source: Chart by Bloomberg

I see more challenges for growth in Regions and more cost cutting ahead.

U.S. Bancorp (USB)

Source: Chart by Bloomberg

U.S. Bancorp is perhaps one of the better banks in the U.S. market. It wants to stay in business even if that means a more modest growth rate. The case in point is the run-up in U.S. financials leading to the mortgage mess starting in the summer of 2007.

U.S. Bancorp was fine. It didn’t need any funds or assistance from the Troubled Asset Relief Program under 2008’s Emergency Economic Stabilization Act. But it went along with parts of the TARP as to not make its peers look bad.

Source: Chart by Bloomberg

But this doesn’t make things much better for the shareholders. The bank has seen its NIM drop to a current level of 3.2%. And with costs out of control, the efficiency ratio is up sharply to 60%.

To be fair, USB has been better at attracting deposits, with growth running at 4.8%. And its bankers have been doing something as loan growth is up by 4.4%. But that loan growth is still way lower than levels throughout 2016.

The return on assets is a bit healthier at 1.4% as is the return on equity running at 14.5%. The conservative nature of the bank has NPA to total assets and total loans at barely-there levels of 0.2% and 0.3% respectively. So, the bank isn’t going anywhere even if the U.S. economy reverses.

But shareholders and the stock market have not been kind to the stock. The return trails the S&P 500 and KBW Bank indices. And this stock performance also shows up in the valuation of the bank with P/B and P/S ratios both drifting lower over the trailing three years.

Source: Chart by Bloomberg

Now a further word about banks in the U.S. and the elections. With the current administration, banks have gotten a little bit of relief. But if there is a change of guard on Nov. 3, banks will be in further peril with projected ramp-ups in regulatory issues and capital requirements. This is perhaps (outside of petroleum-related companies) the most at-risk sector in the election run-up.

Bankers Busted & Bested

Every industry has its disruptors. The old and established leaders get comfortable doing things the same way, because that’s what has worked for decades. Sometimes disruptors come with new ideas and approaches. Others come with new technologies.

Banking is getting it badly. Technology companies referred to as financial technology (fintech) continue to rapidly rollout non-bank payment, loan and deposit apps. These are increasingly making banking with traditional banks less necessary, if not more costly. And even mortgages can be applied for or refinanced via apps.

This has led many newer stocks to grab investor attention including Square (NYSE:SQ) with its alternative mobile payment and point-of-sale services. It may be gathering new adopters with revenue up over the trailing year by 49%, but it has negative operating margins of 1.1%.

And dividends? Not with Square’s cash burn. No wonder that in the trailing year insiders have been reporting millions upon millions of shares sold — not bought. Bad indicator.

Then there’s Fiserv (NASDAQ:FISV) which provides behind-the-scenes services to alt-financial companies. This company is a bit more responsible, with operating margins running at 30.1%. Those margins in turn are helping the return on equity reach a meager 5.3%. But its sales are anemic with gains over the trailing year of only 2.2%.

Fintech might be a good disruptor for beating traditional banks — but not so rewarding for investors. But what are beating and besting traditional banks are what I call alt-financials. These companies are doing what banks used to be good — making loans and earning lots of interest and fee income.

Alt-financials come from three obscure bits of Congressional legislation: The Investment Companies Act of 1940, the Small Business Investment Incentive Act of 1980 and the Cigar Excise Tax Extension Act of 1960.

Bank Business Developers

Back in the late 1970s, inflation was out of control, driving interest rates to the moon. This made banks reticent to lend, since they didn’t know what to expect in return. So, the 1980 legislation allowed non-banks to operate as investment companies which could make loans and invest in financing facilities. This began what are largely known as business development companies (BDCs) which also do not have to pay traditional corporate income taxes.

BDCs have been a very successful business model over the past many years. They continue to outperform banks in total return, as measured by the MVIS BDC Index compared to the KBW Bank Index.

Source: Chart by Bloomberg

BDCs are outside much regulatory purview and they don’t do deposits. And it shows in the performance of the MVIS BDC Index, generating a trailing year return of 20.8% including an average trailing tax-advantaged dividend yield of 9.3%. This compares to the KBW Bank Index return of 16.8% and its lower average yield of 2.7%.

Moreover, BDCs also participate in the business loan market. Although this market can be shady, well-run BDCs can participate in senior loans, adding them to their portfolio assets. And senior loans continue to perform well, even as non-bank companies continue to grab more of the business loan market.

Source: Chart by Bloomberg

Bank Stocks to Buy: Hercules Capital (HTGC)

Source: Chart by Bloomberg

In the model portfolios of my Profitable Investing, I have a great BDC in Hercules Capital (NYSE:HTGC). Hercules is based in Palo Alto, California, with offices around the nation. It focuses on working with technology companies and has a good track record of financing startups to become bold-faced names in the tech market. HTGC makes loans and provides other financing and also takes equity participation in its portfolio companies. It then works with them like bankers used to do, by guiding them along to an exit strategy.

NIM is ample at 9.4% and the efficiency ratio is good at 52.5% (the lower the ratio, the greater the profitability, as noted earlier). Revenues are up 8.8% for the trailing year and it feeds a nice annual dividend stream including regular special distributions yielding 9.2%.

And note, I have Hercules Capital as my one stock for 2020 in InvestorPlace.com’s Best Stocks for 2020 contest.

Main Street Capital (MAIN)

Source: Chart by Bloomberg

Then I also have Main Street Capital (NYSE:MAIN) inside Profitable Investing. This BDC focuses on more mundane small to middle-market companies. It has wide financial margin and an efficiency ratio of an amazing 8.2%. Plus it pays an annual dividend — including regular special distributions — yielding 6.6%.

TPG Specialty Lending (TSLX)

Source: Chart by Bloomberg

Then there is my recommended TPG Specialty Lending (NYSE:TSLX). This alt-financial provides financing and capital to a variety of companies, including loan assets in its portfolio. TSLX is part of the famous TPG Capital, formally the Texas Pacific Group. TPG is one of the largest and most successful private equity firms in the world. It’s safe to say that TPG Specialty draws great talent and resources from its affiliate.

Revenues are up on a tear with the trailing year climbing by 24.2%. Its NIM is running at 10.2% and it keeps its efficiency ratio humming at a profitable 31.5%.

The company has generated a return of 101.1% over the trailing five years for an average annual equivalent of 15%.

It pays regular dividends quarterly providing a yield of 7.1%. But thanks to special payments, its dividend is closer to a yield of 8.3%.

MFA Financial (MFA)

Source: Chart by Bloomberg

Banks used to be big in the mortgage business. That’s been changing, particularly after 2007-2008. Now others are in the market to originate and own mortgages. Inside my model portfolios of Profitable Investing I have MFA Financial (NYSE:MFA) which is structured as a REIT under the Cigar Excise legislation noted earlier.

MFA owns and runs a mortgage portfolio, which in turn fuels an ample dividend yielding 10.1%. And it has proven itself during times of adversary.

Over the past ten trailing years MFA has delivered a return of 258.5% for an average annual equivalent of 13.6%. Buy it in a taxable account as 20% of its dividends qualify as deductible from income tax liabilities. That makes its payout distributions even more attractive after taxes.

Neil George was once an all-star bond trader, but now he works morning and night to steer readers away from traps — and into safe, top-performing income investments. Neil’s new income program is a cash-generating machine … one that can help you collect $208 every day the market’s open. Neil does not have any holdings in the securities mentioned above.


Article printed from InvestorPlace Media, https://investorplace.com/2020/01/4-bank-stocks-sell-alternatives-buy/.

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