It has been an interesting few weeks. While Federal Reserve officials have been hyping up the possibility of raising interest rates in June or July, Friday’s incredibly poor jobs report seems likely to delay any hike until September at the earliest. For many short-term oriented traders, bank stocks have become a trading tool to speculate on interest rates. There is no doubt that banks will indeed benefit when rates go higher unlike the vast majority of companies.

This sort of trading is shallow and is a major reason why there is a strong likelihood that we will make a tremendous amount of money on the big banks.

In valuing banks one must look at:

  • balance sheets
  • competitive position
  • future earnings power of the enterprises

Currently, bank balance sheets are the strongest they have been in many decades. No industry is more carefully scrutinized, or reviled for that matter. There are literally regulators that work out of the offices of the banks, pouring over the books and transactions. Capital and liquidity ratios for the big U.S. banks are higher than they need to be after years of retaining earnings to meet the enhanced regulatory standards. Which in turn means banks will have to do something with excess capital. This really leaves them with three options:

  1. If the economy was great you’d probably see balance sheets grow, but that is very unlikely especially as the Federal Reserve seems ardently resolved to make it less attractive to be a big bank.
  2. The other options involve increasing dividends and
  3. buying back stock. While in a yield-starved universe, dividends are preferable for many investors, the reality is that the Federal Reserve prefers stock buybacks which can be cut more easily than dividends in times of economic duress. There is little doubt that as the dividend yields grow, the stock prices will follow but truthfully for long-term investors, stock buybacks are actually preferable.

With banks such as Citigroup, Bank of America, Morgan Stanley and Goldman Sachs trading at considerable discounts to tangible book value, buying back stock allows for a rapid appreciation of intrinsic value per share. It is like buying dollar bills for 60 or 70 cents.

Obviously in this low interest rate environment, growing dividend yields would be incredibly attractive to most investors.  While today’s low interest rates are a negative for the big banks, at some point rates will go up and the banks will be one of the few industries that benefit.

This increases the possibility of considerable earnings growth, which could lead to a revaluation of the industry and the stocks that comprise it. 

In a “normal” recession most of the big banks would likely still be profitable.  These franchises have exited many of the businesses that strained their balance sheets and caused problems in the Great Recession.  Maintaining profitability is important as it allows these companies to continue to grow tangible book and regular book value per share.

With the stocks trading at huge discounts to these metrics, very little actual “growth” is needed to produce outsize returns. 

Even if the stocks just traded back to their growing tangible book values, we would likely obtain earnings well in excess of 12-15% per annum over the next 3-5 years.

It is important to understand that the reason many of these big banks don’t pay higher dividends is because the Federal Reserve regulates capital distributions. While the big banks easily meet the quantitative metrics, which would enable them to return more capital, they have had problems with the qualitative aspect of these tests. These are subjective evaluations that have a lot to do with relationships and truthfully political motivations. If all the banks passed all the tests, it might look like regulators are “weak on Wall Street,” which would clearly be politically disadvantageous. This situation won’t last forever as the banks can’t build capital forever. While many focus on current dividend yields, it is more helpful to look at earnings yields.

For a company like Citigroup, the earnings yield based on last year’s earnings is around 12%. 

This means that if Citigroup were to pay all of its earnings as a cash dividend, the yield would be 12%. Obviously if they paid out just 50%, the yield would be 6% and the other 50% of earnings would be available for stock buybacks and to fund growth. The earnings yield can be a good guide to where the dividend yields are heading over time. As the market begins to appreciate this story, which is based simply on math and not projections of a great economy or environment for the big banks, the stocks will very likely begin a major turn upwards. At current valuations, there is very little risk in my opinion as these companies are being valued as if they would be worth more dead than alive, despite making tens of billions of dollars per year.

Below is a recent analyst report that predicts Citigroup doubling by 2020, which I agree with. I hope that you enjoy!

Citigroup Shares Seen Doubling by 2020 on Capital Returns