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U.S. Large Cap Banks


Viking
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It looks like sentiment is slowly getting more positive in U.S. large cap banks, especially BAC, Citi and JPM. My thesis with large cap US bank stocks is over the next couple of years we are going to get

1.) increased earnings

2.) lower share count (as excess capital is used to buy back stock)

3.) sentiment change resulting in Mr Market paying higher PE multiple

 

When these 3 things happen at the same time stocks often move 30-50% over 24-36 months. My guess is we are still in the early days in the increase in stock prices of companies in this sector.

 

Over the past 8 years the vast majority of the coverage has focussed on issues: capital issues, credit losses, litigation losses and/or regulatory burden. All of these issues caused earnings to suffer, muted growth rates (top and bottom line) and this resulted in Mr Market valuing the sector with a below market PE multiple.

 

Mike Mayo: "more positive on bank stocks than anytime in the past 16 years"

A: asset quality is stronger than its been in the last decade

B: balance sheets are stronger than they have been in two decades

C: capital is stronger than it has been in 5 decades

 

Litigation: in 8th or 9th inning

Regulation: has hurt earnings growth but has also dramatically reduced risk; not a terrible trade off

Earnings stability: much, much better than the past

 

 

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You are most likely correct. Most prominent value investors own at least one of BAC, JPM, or WFC. The big question is which one to own? I own WFC (and a bit of BAC) but suspect that the more marginal banks (BAC) will do better if interest rates rise and lending picks up.

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The question I'd ask is why own large when you can own regional banks?  They are going to benefit from the same market conditions, but their results should be more dramatic.  They have more loan growth, more room for growth and improvement and they're more technologically advanced.

 

Regional banks also don't have the stigma associated with large banks.  In the collective mind BAC, C, WFC, JPM "caused" the financial crisis.  Banks like Regions, Zion, PNC, BB&T etc are seen as victims of the large bank action, not actors.

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There are certain business lines, (mostly investment banking businesses) where large banks are significantly more advantaged.  But that's the  business line that's most in question these days.  Going back to the late 90's, the narrative is quite different about whether commercial banking or investment banking is the better business to be in.  Today, everybody can't run away from IB fast enough.

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I don't follow the regional chains in the U.S.; my understanding is the regional banks currently trade at a higher multiple than the large cap banks. My guess is the entire sector will do well.

 

Regarding ranking the large U.S. banks currently I like JPM the best. I think they have the best management group. And each of their 4 businesses are solid franchises that will only get stronger from here. JPM looks like they are a few years ahead of Citi and especially BAC in executing their strategy to prosper in the current environment. If I had to own one name for the next 10 years I would pick JPM in a heartbeat.

 

Looking a possible returns over the next 6-12 months it is really difficult to pick a clear favourite as each company offers something different. Citi looks quite cheap given earnings projections the next couple of years and they will be returning lots of excess capital (as they utilize their tax loss carry forwards). BAC looks the cheapest but it also looks like it has the most legacy issues to still work through and I have the least confidence in its leadership group.

 

Bottom line, it looks like the headwinds are diminishing and the tailwinds are picking up some speed.

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The question I'd ask is why own large when you can own regional banks?  They are going to benefit from the same market conditions, but their results should be more dramatic.  They have more loan growth, more room for growth and improvement and they're more technologically advanced.

 

Regional banks also don't have the stigma associated with large banks.  In the collective mind BAC, C, WFC, JPM "caused" the financial crisis.  Banks like Regions, Zion, PNC, BB&T etc are seen as victims of the large bank action, not actors.

 

1. Because it's easier with all the information out there.

2. Leverage. Cheaper and better. Again, easy.

3. Regional banks are now in the spotlight, more and more will get hit with penalties and regulation.

 

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The question I'd ask is why own large when you can own regional banks?  They are going to benefit from the same market conditions, but their results should be more dramatic.  They have more loan growth, more room for growth and improvement and they're more technologically advanced.

 

Regional banks also don't have the stigma associated with large banks.  In the collective mind BAC, C, WFC, JPM "caused" the financial crisis.  Banks like Regions, Zion, PNC, BB&T etc are seen as victims of the large bank action, not actors.

 

1. Because it's easier with all the information out there.

2. Leverage. Cheaper and better. Again, easy.

3. Regional banks are now in the spotlight, more and more will get hit with penalties and regulation.

 

I don't disagree.  Although it seems there is this regulatory hammer that is focused on the large banks with the potential to lighten up on the regionals.  There were some proposals to only have the most stringent requirements on $500b and larger banks, effectively the big 4.  The deck is stacked against these banks.  Consider that they can't grow by acquisition either.

 

They are cheap, I agree.  But when you've got a Bush coming out saying that they're TBTF you know the deck is stacked.  When a Republican, and a Bush is saying this I don't think we'll be seeing looser regulations on the largest banks.  Now maybe there's a trade in here where these banks get broken up.  Talk about unlocking value, that'd be incredible.

 

Someone earlier mentioned scale advantages.  I don't believe you gain much/any scale going from $300b to $1.8t.  From what I've heard second-hand there is a reverse-scale effect going on where the larger the bank the more bureaucratic and harder to get things done.  The FDIC's study on scale showed most scale advantages happen at $250m in assets, and they almost evaporate at $500m in assets.

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Internationally, is the U.S. better served by having banks of similar or greater size than other countries' largest banks, or many smaller banks?  I would guess that the U.S. might prefer smaller but a fear of giant Chinese or other banks somehow dominating international markets would cause the U.S. to look the other way.

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Oddball,

 

But quality regionals are all trading at higher P/B compared to BAC, JPM. I guess it might be valid comparison against WFC.

 

I might agree that low P/B of BAC is somewhat deserved though. :)

 

I believe they have a lower P/B because of the lower growth opportunities plus the regulatory overhang.

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Oddball,

 

But quality regionals are all trading at higher P/B compared to BAC, JPM. I guess it might be valid comparison against WFC.

 

I might agree that low P/B of BAC is somewhat deserved though. :)

 

I believe they have a lower P/B because of the lower growth opportunities plus the regulatory overhang.

 

For better or worse, when you buy the megabanks you get big asset management, wealth management, and investment banking arms, so I think they are different animals. Obviously some of the regionals and community banks have division like this (PNC owning 20% of BLK comes to mind), but I'd argue it's to a lesser extent. When you go mega you get a more diversified business model less dependent on good old deposit taking and lending. Some may see this as a negative and others as a positive.

 

All else equal I'd rather own JPM with JPAM and the I-Bank than Chase (I don't currently own), even with the inevitable, occasional London Whale fiasco or GS with GSAM and BAC with Merril etc.

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These is a great deal of noise right now when trying to understand the mega banks. What will litigation costs normalize to and when? What will the final regulations look like? How much capital will they be required to hold?

 

The more interesting questions to me are: Will banks completely exit certain business lines? What banks will exit what business lines? For those who are left in a segment how will pricing change? Will we be left will oligopolies and if so will pricing decisions be rational? How will individual banks and the industry respond to the final capital requirements?

 

Capital return is also a great unknown. Yes, the mega banks are not able to grow. So instead of using earnings to fund acquisitions they will instead have to return it to shareholders. This is not a bad thing in my mind as many large acquisitions are often not good for existing shareholders. In two years, JPM will likely be earning $27+ billion per year (and growing). They will need to build no more capital. They will not be allowed to make large acquisitions. They likely will pay out 75% to shareholders in regular dividends, share buyback so and perhaps a special dividend ($5 to $6 per share is possible). Over the next two years the narrative with the big banks is going to change in a major way; as people come to understand the size of how much capital is going to be returned to shareholders sentiment is going to shift (greed is a beautiful think to get interests aligned). The big banks are cash machines. All of the regulation is creating huge barriers to entry. The big banks are looking more and more like a regulated utility to me... with a yield (looking out 2 years) of better than 10% and growing. the risk of owning US large cap banks is likely the lowest it has been in decades. Low risk and high return... Not many opportunities like this available in the market today.

 

My read is in the current environment (lots of important strategic decisions to be made) quality of management is going to be more important than normal. Banks that have been making and continue to make the best decisions are going to come through this period in very good shape: less competition, larger moat, more stable and predictable business results. The key for owners of bank shares is to simply do nothing...

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