Published May 21st, 2018 by Josh Arnold
The four money center banks in the US have been the source of much investor and media attention in the years since the Great Recession. The group suffered mightily at the hands of the worst economic downturn in decades and two of them were brought to the brink of insolvency as a result.
Finance stocks in general suffered during the Great Recession, but many have fully recovered – and then some. You can download the full list of all 1,000+ dividend paying financial sector stocks below.
In addition, these once-strong dividend stocks were reduced to smaller payouts for years, but are in the process of restoring those shareholder distributions; some have made better progress than others.
However, the past decade has rejuvenated the group and in this article, we’ll rank them in order of attractiveness on a total return basis, as derived from our Sure Analysis database. Rankings are compiled based upon the combination of current dividend yield, expected change in valuation as well as forecast earnings-per-share growth to determine which stocks offer the best total return potential for shareholders.
Related: Watch the video below to learn how to calculate expected total return for any stock.
Read on to see which of the four biggest US banks ranks as the most attractive for investors today.
Big US Bank #4: JPMorgan Chase & Company (JPM)
JPMorgan Chase can trace its lineage back to 1799, making it one of the oldest surviving banks in the US. The company has a strong global reach in consumer and community banking, commercial and investment banking, as well as asset and wealth management. JPM focuses heavily on consumer lending via its huge mortgage, auto and credit card loan operations, but has a vibrant mix of non-lending activities as well. JPM is the product of more than 1,200 different entities that have merged in the 219 years since its creation and is the largest bank in the US by market cap, as JPM’s market value is in excess of $370B.
JPM is widely considered the benchmark for other large banks in terms of its revenue diversification, tremendously strong balance sheet and sizable capital returns to shareholders. That strength and perceived best-of-breed status has led to the stock being more robustly valued than the rest of the group in recent years, meaning it is now slightly less attractive for value investors. However, stellar results continue to come in, as evidenced by its recent Q1 report.
Source: Q1 Earnings Slides, page 1
Q1 highlighted the favorable trends that JPM has continued to see in its results in recent years, the product of world-class leadership and strong stewardship of shareholder capital. EPS rose 37% excluding a one-time gain as lower provisions for loan losses and higher core loan balances helped JPM produce higher earnings. JPM’s overhead ratio remains in the mid-50% range, which is fairly strong for a large bank, but there is certainly further room for improvement going forward. Pre-crisis overhead ratios were sub-50% during the boom years and while we may not see them that low again – due to increased regulatory oversight costs and heightened scrutiny from regulators in terms of revenue generation – JPM still has that lever to pull going forward.
JPM’s profitability is already exceptional at 19% return on tangible common equity, or ROTCE, which is part of the reason why investors have valued it so richly. It also compares quite favorably to the 13% ROTCE JPM achieved in last year’s Q1. However, as terrific as its current level of profitability is, as measured by ROTCE or any other measure, that leaves very little room for growth going forward from profitability improvements on a large scale. JPM has some upside potential here but as it is further along than the other banks, its growth potential from here is rather limited.
JPM’s balance sheet remains among the best in the business as it came through the Great Recession as an acquirer and in better shape than it was prior to the downturn. JPM has built upon that strength and its fortress balance sheet principles in recent years, as Q1 was yet more evidence the strategy is working. Common Tier 1 Equity was 11.8%, right in line with where it has been for years at this point. The big banks are in a constant balancing act in terms of investing capital and saving it as the former allows for growth but the latter is required for a strong balance sheet. JPM’s balance sheet is tremendous but don’t look for sizable improvements going forward; like its profitability, JPM’s balance sheet is already outstanding.
The bank’s dividend was slashed during the crisis of course, but payout growth in recent years has been very strong, affording JPM a 2% yield at present despite an enormously bullish run in the stock price. JPM’s dividend will continue to grow handsomely in the years to come as its payout ratio is still very low indeed, and we see the yield therefore approaching 3% in the next few years.
JPM’s earnings outlook isn’t as bright as the other big banks because its profitability is already excellent, it has a lot of leverage to the flattening yield curve via its enormous consumer and commercial lending operations, and its credit card portfolio is huge as well, accounting for nearly half of its revenue in the flagship community and consumer banking business. Credit card losses have surged in recent quarters as credit quality has come off of unsustainable highs. This has been a problem for all credit card lenders but given JPM’s sheer size in the space, the damage is more acute.
JPM’s valuation is the highest among the four largest banks at 12.8 times 2018 estimates. Its long term average P/E multiple is 11.1, implying a moderate headwind to total annual returns going forward. This normalization of the valuation should impair total returns by 2.8% annually, making JPM less attractive than the other three.
JPM is on track to deliver respectable total returns in the next five years of 4.7% annually, consisting of the -2.8% headwind from the valuation, the current 2.0% yield as well as 5.5% EPS growth. We therefore see JPM as a stock trading moderately in excess of fair value and thus, it is less attractive than the other three money center banks at this time, particularly given its low current yield.
Big US Bank #3: Citigroup (C)
Citigroup has been in the banking business since 1812 when it was known as the City Bank of New York. This humble beginning during a tumultuous time in US history eventually gave way to a global powerhouse with interests in credit cards, commercial banking, trading and a variety of other related activities. It has thousands of branches all over the world and has a $178B market cap today, making it the smallest of the large money center banks, although “small” is certainly used as a relative term in this case as Citigroup is anything but.
Citigroup certainly had the furthest to come from the bottom in terms of recovering from the crisis. The stock famously fell below $1 briefly during the worst of it but the eventual bailout and years of hard work have paid off for Citi and it certainly is in much better shape than it has been in recent years. Indeed, while Citi is far from perfect, it’s recently reported Q1 showed it continues to make progress towards what were once lofty goals; a strong balance sheet and a balanced outlook for growth and risk.
Citi produced continued growth in its core businesses, partially offset by the ongoing wind-down of legacy assets it is trying to rid itself of. Total revenue growth was 3% but EPS was up 24%, driven by better margins, a lower tax rate, as well as a 7% reduction in the share count. Citi’s transformation that began after the Great Recession and subsequent bailout continues through today and the results have been tremendous. Its capital ratios are well above industry standards and it is once again returning billions of dollars to shareholders.
Citi’s net interest margins are of particular concern, however, as gains have come from a lower efficiency ratio but Citi’s exposure to consumer lending, namely credit cards, sparks concern about its profitability growth going forward.
Source: Q1 Earnings Slides, page 10
We can see here that Citi’s NIM has fallen rather meaningfully – 12bps – YoY as it contends with higher loss rates in the consumer loan portfolio as well as higher deposit rates. The flattening yield curve isn’t as large of a concern for Citi as it is for JPM, but higher card losses are very much a concern for Citi. In addition, every rate hike that produces higher short term rates will squeeze margins for Citi as funding costs move up; that is what we are seeing in the chart above. This won’t cause an outright decline in earnings for Citi but it will keep a lid on growth.
We still see 8.1% EPS growth going forward but the bulk of that will come from the buyback, which Citi has only recently been allowed to resume in earnest. Higher reward costs as well as higher loss rates are crimping Citi’s critical credit card business’ margins, although its global footprint and high level of diversification of revenue should keep the damage limited. We think Citi will see a mid-single digit tailwind from the buyback as well as a low single digit rate of revenue growth going forward given robust economic strength around the world but keeping in mind the concerns raised above.
Citi’s balance sheet is in outstanding shape, which is probably something that was unfathomable during the height of the crisis. Its common equity tier 1 ratio is still in excess of 12% after peaking last year above 13%. Citi spent years hoarding capital as a necessity as it was trying to dig itself out of the considerable hole it found itself in during the Great Recession. In recent quarters it has been able to return much more capital to shareholders in the form of a dividend as well as the buyback, both of which combined for over $3B in Q1 alone.
The dividend was obviously slashed in the aftermath of the crisis, falling to just one penny per quarter until 2015 when it began moving higher. The stock now yields nearly 2% and while that means Citi hasn’t yet regained its income stock status, it means it isn’t far off. We see high rates of dividend growth going forward and eventually, the yield should approach 3% once again.
Citi’s current P/E multiple of 11 is slightly higher than its historical average of 10.5 and as a result, we see the stock as only slightly overvalued. Citi’s average P/E multiple is lower than that of its peers as it has been the one in the group with the most improvements to make. It has done so over the years but still stands with the most to gain going forward and as a result, it is unlikely to trade on par with the others anytime soon.
We still see total returns of 8.8% annually going forward, consisting of the current 1.8% yield, 8.1% EPS growth as well as a 1.1% headwind from the stock being slightly overvalued today. Citi looks fairly attractive here for those seeking growth as well as dividend growth, but would be inappropriate for those seeking value or a high current yield.
Big US Bank #2: Wells Fargo & Company (WFC)
Wells Fargo was founded in 1852 and provides banking, investments, mortgages, as well as consumer and commercial financing products through more than 8,000 locations in 42 countries. The company’s 260,000 employees help WFC invest its $2T in assets to produce nearly $90B in annual revenue. WFC’s market cap is $262B, which makes it the third largest bank in the US behind Bank of America and JPMorgan Chase.
WFC’s recently reported Q1 was a mixed bag as EPS grew almost 9% but revenue was down slightly. The company’s weak revenue was due to lower loan balances as WFC has been subject to a regulator-imposed asset cap due to its many issues related to how it has treated consumers in recent years. Indeed, WFC said its Q1 results could change based upon a proposed $1B settlement with the CFPB regarding those issues. On an operational basis, net interest income was flat YoY but still fairly strong at 2.84%, and return on assets was 1.26%, a number most of WFC’s competitors would envy.
As we can see above, for all the good things WFC has done to improve its profitability, it is still largely missing its own targets. WFC set ambitious but realistic goals during its 2016 Investor Day of 11% to 14% ROE and 1.1% to 1.4% ROA. Both of those numbers are very strong indeed but keep in mind that WFC was considered the gold standard for large banks prior to – and even following – the crisis. These are numbers that were easily bested in the past by WFC but recent deterioration in the mortgage market in particular – where WFC has an outsized market share – has made profitability growth difficult.
In addition, WFC has seen numerous problems pop up from mistreatment of consumers in a variety of different ways. These issues will be settled for a sum that will likely be in excess of $1B, but the reputation damage WFC has suffered is the larger cost. Whether or not WFC can convince consumers to place their money with the bank is the biggest short term variable when it comes to WFC’s profitability outlook. As we can see in the slide above, it has a lot of work to do on that front.
WFC does have an advantage over the other three large banks in its balance sheet composition. WFC’s balance sheet has always been strong – even through the crisis – but its higher mix of deposits means that it relies less upon the capital markets for funding and it also means its cost of funding is lower. WFC gets nearly 70% of its funding from deposits that carry a weighted-average cost of just 34bps. That means WFC’s funding is not only ample but cheap as well, allowing it to preserve some margin at a time when rising short term rates and flat long term rates are working against it. WFC’s leverage to the mortgage market is particularly problematic these days, but we still see meaningful growth ahead.
Part of that growth will come from capital returns, which WFC is still producing lots of today. It spent $4B in Q1 alone on a combination of dividends and buybacks, both of which we see as contributing significantly to total returns going forward. The current yield of 2.9% is the strongest in this group by a significant margin, and we expect the dividend to roughly keep pace with the share price moving forward. Thus, for income investors that want a high current yield, WFC is the superior choice and we don’t see its income stock status as changing in the future.
We are forecasting 5.9% EPS growth in the coming years, consisting of a small amount of revenue growth, a low single digit tailwind from margin increases and the bulk of total growth coming from buybacks. WFC still has a regulator-imposed asset cap and likely will into next year, meaning it is handicapped in terms of revenue growth until then. We also see brand image damage from the many issues WFC has thrust upon itself crimping growth in the near term. Further, WFC’s leverage to the mortgage market makes it more sensitive to the slope of the yield curve than the other money center banks; a negative as of now as the yield curve continues to flatten. However, WFC remains highly profitable and should be able to reduce the share count in the mid-single digits annually, producing the bulk of its EPS growth. In addition, a lower tax rate will help WFC improve profitability in 2018 and beyond, but operationally, we still see WFC has having some fairly meaningful operational concerns.
The valuation is actually right on par with historical levels at this point as WFC trades for a P/E multiple of 11.9 against an average of the same amount. We therefore don’t see the valuation as having any sort of substantial impact positively or negatively going forward as the stock is fairly valued today.
Overall, we see WFC as fairly valued here and with decent growth prospects. We are forecasting 8.8% total annual returns, consisting of the current 2.9% yield and 5.9% EPS growth; the valuation should have no impact going forward. That makes WFC suitable for investors seeking a safe, high current yield but its growth issues as well as the valuation make it such that value and growth investors may find it unattractive. We see the primary source of EPS growth going forward in the form of the buyback, meaning risk to estimates is low, but WFC is far from being at its best today. It is, however, the highest-yielding large bank in the US today.
Big US Bank #1: Bank of America (BAC)
Bank of America was founded back in 1904 and since then, has grown into a global juggernaut in the banking world. The company’s focus is still in the US and it has built a strong presence in credit cards, consumer and commercial lending, wealth management and more. The company’s market cap is in excess of $300B today, making it the second largest bank in the US and one of the largest in the world.
The company’s recently reported Q1 was stellar as its EPS rose 37% against last year’s Q1. Strength came from all of its segments but in particular, consumer banking. Lower mortgage income was more than offset by higher loan balances that led to a 13% jump in net interest income. Equity trading was another bright spot during the quarter as income in that segment of Global Markets was up a whopping 38%.
Source: Q1 Earnings Slides, page 3
Bank of America certainly had a long way to come from the crisis days when it lost money for years, even after its competitors had moved on and were making money again. Legacy issues like the Countrywide acquisition haunted BAC until only recently and as a result, it is still very much in the middle of its improvement efforts. That is a big reason why we see the stock as the most attractive large bank at this point because it is still not as efficient as it could be, as evidenced by the slide above.
BAC has produced positive operating leverage for 13 consecutive quarters, a very impressive feat that has been years in the making. BAC was once bloated in terms of headcount and that led to higher costs to produce revenue than its competitors. However, the trend in operating leverage you see above is the principal source of earnings growth we see going forward as BAC still has ample room to improve margins from the cost side; its relentless focus on operating expenses for years is paying off and will continue to do so moving forward.
The company’s extraordinary turnaround has afforded it the ability to return billions and billions of dollars to shareholders each quarter, something that for years was impossible.
This slide shows just Q1 of this year and apart from the sizable increases in different forms of earnings, capital returned increased by 92% YoY. Dividends increased 64% to $1.2B and buybacks doubled to $4.6B. We see this as not only a strong source of EPS growth going forward via a lower share count, but we are forecasting the dividend to more than double from today’s level in five years. The capital return story is a big one at BAC and it is far from over in terms of recovering from the crisis. This would make BAC attractive for investors seeking dividend growth more so than the other large banks.
BAC’s earnings outlook is strong as we expect better than 8% EPS growth annually going forward. We expect much of this will come from the buyback but BAC is also growing its loan portfolio in the mid-single digits and its operating leverage continues to provide the opportunity margin expansion. Combined, these factors should produce high single digit EPS growth annually for the foreseeable future and at the current valuation, that makes BAC very attractive.
We forecast BAC’s P/E multiple will rise from the current 12.4 to a more normalized 13.5 going forward as the market digests a lower tax rate as well as BAC’s best-of-breed growth potential. That should provide a modest 1.7% tailwind to total returns going forward.
Speaking of total returns, we see BAC as providing 11.5% to shareholders annually for the next five years consisting of the 1.7% valuation tailwind, 1.6% current yield as well as 8.2% EPS growth. BAC’s shares have outperformed of late but we do not see this as being completed just yet as the fundamental outlook for BAC is superior to those of the other three big banks. As a result, we see BAC as the best choice among the group.