The U.S. financial sector has been one of the market’s poorest-performing sectors over the past year. Banks have had to deal with a number of headwinds, including slowing global economic growth, higher than normal litigation expenses and more recently the Brexit vote, which stands to harm banks in Europe. If all that wasn’t bad enough, U.S. banks have had to deal with the additional headwind of persistently low interest rates.
This has weighed on profitability across the financial sector over the past year, but fortunately several big banks finally received some good news. On June 29, the Federal Reserve released the results of this year’s stress test. With their capital plans either approved outright or acceptable pending clarification on certain items, major U.S. banks including State Street (STT ), US Bancorp (USB ), Morgan Stanley (MS ), Citigroup (C ) and Bank of America (BAC ) announced significant dividend raises and, in some cases, approved huge new share buyback programs as well.
These five banks’ share prices have under-performed the S&P 500 over the past year, but the recently approved dividend increases and share repurchases could be very positive forward catalysts for these stocks.
What is the Stress Test?
The crash of the financial sector almost brought the entire U.S. economy to the brink of depression in 2008. The ensuing bailout of the financial sector cost U.S. taxpayers hundreds of billions of dollars. Now that many financial institutions have been deemed too-big-to-fail – in light of the systemic risk their failure can spread across the entire economy – the Federal Reserve conducts annual stress tests. These are hypothetical scenarios that gauge how the major U.S. banks would perform in adverse conditions, including future economic recession or another financial crisis.
In all, there were 33 banks tested, 31 of which passed. Only two did not pass, and those were Europe-based banks. All U.S. headquartered financial institutions passed the stress test, indicating that the U.S. financial sector is in much better health since the 2008 bailout. Regulators have steadily expanded the hurdles to pass the stress tests each year, and banks have proven that they are stronger than at any point since the Great Recession, and are sufficiently able to incur significant losses from future economic recessions.
For example, in recent years the banks have shifted their capital structures. They are relying less on borrowed money through debt, and instead have raised more funds through equity. This is key to avoiding another financial crisis, as one of the key contributors to the Great Recession was the over-indebtedness of the U.S. banks. With more capital provided by equity, banks are nimbler and can more easily navigate stresses to the financial system. This is why the banks performed better than many would have expected during the recent Brexit crisis.
In the past week, the Federal Reserve released the results for two rounds of stress tests. The banks easily passed the first round, and it is a very good sign that the vast majority also passed the second round. Banks and their shareholders closely watch the results of the annual stress tests, which have been released at this time of year since 2011 when the Federal Reserve ruled that banks would have to submit to stress tests on an annual basis. That is because the result of the stress tests largely determines whether banks are able to increase their cash returns to shareholders, including dividend increases and share repurchases.
Banks have demonstrated reluctance to have to submit to these tests each year. Indeed, there are significant compliance costs – in the billions of dollars – for banks to submit and comply with stress test hurdles each year. Moreover, banks have widely stated that the Federal Reserve is risking choking economic growth with over-regulation. However, at the same time, banks have also acknowledged they are in much better financial condition than at any point since the financial crisis due to the stress tests.
Positive Results Allow for Increased Capital Returns
State Street will increase its quarterly dividend by 12%, from $0.34 per share to $0.38 per share. The new annualized dividend rate of $1.52 per share represents a 2.9% dividend yield. In addition, the company announced a new $1.4 billion share repurchase plan, which amounts to 6.8% of its current market capitalization.
US Bancorp announced a third-quarter dividend of $0.28 per share, 10% higher than its previous dividend level. The new dividend rate will be $1.12 per share, which presents a current dividend yield of 2.8% based on its current share price. Furthermore, US Bancorp approved a $2.6 billion share repurchase program, which represents 3.8% of its market capitalization.
Morgan Stanley was the only one of these five major U.S. banks to have a contested capital allocation plan. The Federal Reserve notified Morgan Stanley that it would need to resubmit its capital plan, but this does not prevent the company from raising its dividend as it wishes. Morgan Stanley announced a 33% dividend increase and a new $3.5 billion stock buyback, which represents 7.2% of its market capitalization. Morgan Stanley’s current dividend yield rises to 3.2%.
Citigroup more than tripled its quarterly dividend payout, from $0.05 per share to $0.16 per share. This takes Citigroup’s dividend yield from 0.4% to 1.5% and makes Citigroup a much more competitive dividend stock. In addition, Citigroup unveiled a massive $8.6 billion share repurchase authorization, which represents 7% of its market capitalization.
Lastly, Bank of America approved a 50% dividend increase, to $0.075 per share. On an annual basis, the new dividend rate of $0.30 provides a 2.3% dividend yield. The company also approved a $5 billion share repurchase program, which amounts to 3.7% of its market capitalization.
Banks Hold Attractive Valuations
The fact that these five banks all passed the stress tests and are announcing huge increases to their capital returns is a great sign. However, it is not all good news for the banks. One hurdle left to clear is improving their net interest margin. Since the 2008 Great Recession, the U.S. Federal Reserve has maintained an aggressively easy monetary policy. Although it has curbed some of the measures employed during the financial crisis, such as monthly bond purchases, the Federal Reserve has kept interest rates near historic lows to boost economic activity. This has weighed on the banking sector, as banks need higher interest rates to increase their net interest margin.
Net interest margin is the difference between the interest banks pay on short-term deposits versus the interest they earn on longer-dated loans, such as car loans and mortgages. When rates are low for an extended period, the yield curve flattens, which causes net interest margin to contract. This is why the banks demonstrated fairly unimpressive financial results in 2015.
State Street’s total revenue was flat last year. Growth in its fee income was offset by a 7.6% decline in net interest income. This caused net profit to decline 5.6% for the full year to $1.8 billion. In response, State Street announced staff reductions designed to save the company $550 million by 2020. US Bancorp managed 2.6% earnings growth last year, as it was at least able to keep its net interest margin steady from the previous year. Net interest margin of 3.06% in the fourth quarter was slightly higher than the previous quarter, and is higher than most of its peer group.
US Bancorp is a rare example of a bank that generated earnings growth last year. Its results were boosted by growth in loans and deposits, which grew 4.2% and 6.9% in the fourth quarter, respectively. As a result, US Bancorp generated 1.44% return on average assets last year, which was much higher than its peer group. US Bancorp generates significantly higher returns on assets and equity – as well as higher net interest margin – than most of its competitors, which is why it is one of the highest-quality banks in the financial sector. This is also why US Bancorp is a favorite stock holding of Warren Buffett, Chairman of Berkshire Hathaway (BRK-B ). Berkshire Hathaway is one of the company’s biggest shareholders. As of Mar. 31, Berkshire Hathaway owned slightly more than 85 million shares, representing a nearly 5% ownership stake.
Morgan Stanley’s results last year look impressive on the surface – net profit nearly doubled for the year, from $3.5 billion to $6.1 billion. However, there were many one-time items that suppressed its performance last year, which made for easy comparisons. In 2014, the bank incurred $3.1 billion of litigation costs, and another $1.1 billion of compensation expense deferrals. Excluding these one-time items, Morgan Stanley’s profits would have declined last year.
Citigroup’s revenue declined 1% last year. Its net profit more than doubled in 2015 to $17 billion, but again its growth rate has more to do with easy comparisons. In 2014, Citigroup incurred a huge $3.8 billion charge to settle legal claims related to its mortgage-backed securities and collateralized debt obligation activities. Citigroup has achieved earnings growth because of deep costs cuts – operating expenses decreased 23% in the fourth quarter. Its progress to start 2016 has been muted – net interest margin remained flat in the first quarter, at 2.92%. This is a lower net interest margin than banks are historically accustomed to, which is a significant headwind for future growth. Lastly, Bank of America’s net interest income declined 1.8% last year, and it also reported a decline in non-interest income. This suppressed Bank of America’s revenue, which fell 2% for the year. Its earnings surged last year, but after stripping out the massive legal expenses incurred in 2014, adjusted earnings would have been nearly flat for the year. Bank of America reported a 0.61% return on average assets in the fourth quarter, which was an erosion of 18 basis points from the previous quarter.
Weak net interest margins have caused lower earnings, or only modest growth, throughout the financial sector, which has compelled many banks to cut costs. However, cost cuts are temporary measures to boost earnings in the short-term. In order for banks to generate higher earnings growth organically, they need a higher interest rate environment. In turn, lower earnings have made it difficult for banks to return greater amounts of cash to shareholders, and a separate side effect is that bank valuations are compressed. As their fundamentals have stagnated over the past year, bank stocks have not been able to earn market multiples for their earnings.
All five bank stocks trade for price-to-earnings multiples well below the S&P 500 average of approximately 20. In some cases, specifically Citigroup and Bank of America, the valuation multiples are half the market multiple. Moreover, these banks are also very cheap based on price-to-book, which is one of the most common valuation metrics for financial institutions. A price-to-book ratio of 1.0 means the banks trade at their book values. Below 1.0 means the banks are valued for less than their book value. In the case of Citigroup and Bank of America, they are valued for almost half their book value. The good news is that their cheap valuations are attractive for initiating new positions in these stocks.
The Bottom Line
Seven years from the official end of the Great Recession, and the major U.S. banks are still feeling the effects of the financial crisis. The Federal Reserve has declared a policy that financially-systemic banks need to submit to tough stress tests on an annual basis, so that the banks will not jeopardize the entire U.S. economy as happened during the financial crisis.
Banks have had a difficult time in the past year because interest rates remain extremely low. However, the good news is that the banks have meaningfully shored up their finances. Since these five banks all cleared the stress test, with Morgan Stanley being allowed to resubmit, they are finally able to raise dividends and share repurchases.