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Get More from Banks than a Little Interest

March 14, 2019

The impact to bank stocks post 2008 through October 2016 was dire compared to the recovering general stock market.

From December 31, 2008 through October 1, 2016, the S&P 500 Index generated a total return of 176.40%. But regional bank stocks only managed to generate a total return of 73.81% for the same time period, as tracked by the KBW Regional Bank Index.

KBW Regional Bank Index versus S&P 500 Index—Source: Bloomberg Finance, L.P.

Electoral Win?

The US general elections in November 2016 set the stage for banks to begin their return to normalcy. From November 16 through year-end 2016, the KBW Bank Index rose 9.28% compared to the S&P 500 Index’s gain of 2.84%.

Investors showed optimism that changes might be in store to relieve some of the stresses banks had been under since 2008, and they began to buy them again.

The process of legislative and administrative regulatory reforms began to come into play slowly in 2017. Capital requirements were eased, particularly for regional and smaller banks. Compliance costs were reduced, and review of regulations was more codified and eased, providing more certainty for banks and lower costs for business and consumer business operations.

Regulations were further eased for regional and smaller banks based on raised asset size. This made domestic banks more attractive for investors and also meant that they were able to merge with less threat of more regulation compared to their mega-global bank peers.

Then came the Tax Cuts and Jobs Act of 2017. This brought down the corporate tax rate for banks as well as for all corporations. This was a particular boon for regional banks that were focused on the US market for their earnings. This meant they’d get a significant boost to their after-tax profitability.

It was into these developments that I reiterated my buy recommendations for select regional bank stocks. The sector was beginning to thaw out from the frozen market and was taking action to bolster its loan originations as well as increase its deposit bases.

The best regional banks already had high efficiency ratios reflecting the past cost challenges. But with these regulatory reforms, I saw that these ratios would fall and provide for improving profit margins.

While many were concerned about spiking interest rates, I saw that this was not in the cards. Instead I expected rates to normalize rather than soar. This was based on the low and steady level of inflation, as measured by the Core Personal Consumption Expenditure Index (PCE). This index measures the overall price rise for all consumer spending and not just a configured synthetic basket of prices, which is what the Consumer Price Index (CPI) measures.

The PCE has remained at or below the 2% level through 2018 and into 2019, which the Federal Open Market Committee (FOMC) set as its inflation target. Moreover, the FOMC has been clear that it would be content to see the PCE rise into the mid-2% range in a healthy expanding economy without the need to tighten monetary policy.

Core PCE Index—Source: Bloomberg Finance, L.P.

These factors resulted in improving net interest margins (NIM) for banks. Furthermore, US economic growth is driving more loan activity as well as other business, helping banks generate higher revenues. This was particularly true for regional banks.

Banks to Bank On

Even with the general market’s strong performance so far this year, regional banks have continued to outperform.

And within that sector, two regional bank stocks stand out to me right now: Citizens Financial Group (CFG) and Regions Financial (RF).

Citizens has seen a continued improvement in loan growth, and while its efficiency ratio has room for improvement, it’s sitting at a healthy 59.70%. NIM also continues to improve sharply.

Citizens Financial Improving Loan Growth, NIM & Efficiency—Source: Bloomberg Finance, L.P.

Revenue growth year over year is now running at 15.81%, which should translate into increased profits. The dividend is running at 32 cents per share, upped over the past year by 50%, for a yield of around 3.6%. Another factor that makes Citizens really compelling is that the shares are trading at less than book value.

Regions is showing improvement as well. Loan growth is up about 4% over the same quarter in the prior year, and its efficiency ratio continues to drop, which is a positive. The bank is doing what it promised to cut costs while driving more revenues. NIM is continuing to improve as well.

Regions Financial Improving Loan Growth, NIM & Efficiency—Source: Bloomberg Finance, L.P.

Regions ‘revenue growth is running a bit lower than Citizens’ revenue growth, but it is up significantly from the negative rates throughout 2017. The dividend, having been boosted 46% over the past year, is running at 14 cents per share for a current yield of around 3.5%.

Its price to book value is also well below where banks should be valued, which is another reason to give the stock a look.