Three best U.S. banks for dividend investors

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. After the Federal Reserve released its latest stress-test results, many big banks announced dividend increases or share-buyback plans. I'm here today with Josh Peters, editor of Morningstar DividendInvestor, to take a closer look at these increases and see what investors can expect in the future.

Josh, thanks for joining me today.

Josh Peters: Good to be here. Always, good to be here with good news.

Glaser: So let's talk a little bit about the stress test itself. What was the Fed looking for, and what were the results of those tests?

Peters: Well, there were two components to it. First is that the Fed wanted to see how the 19 largest banks in the country would fare in a recession or a financial crisis even worse than downturn that we went through in 2008 and 2009. Basically, the Fed was looking at whether the banks are generating enough revenue and have enough residual capital leftover that they could withstand literally hundreds of billions of dollars of additional losses on their loan and investment portfolios and still be able to maintain adequate capital ratios.

The second piece of this took the same set of assumptions about profitability, capital, and loan losses, but also included what managements of the different banks submitted in terms of their plans for returning capital to shareholders through dividends and share repurchase. So, what we saw was that most of the banks fared reasonably well on the first test, but there were some in which the Fed came back and said, "We're really not comfortable with you increasing your returns to shareholders at this time because your capital ratios after a period of intense stress would just be too low."

Glaser: Let's look some individual names then. Who failed these tests? Who did the Fed say this capital plan just isn't sufficient?

Peters: Well, of the 19, there were four institutions that didn't pass the test. One of them Ally Financial, the former GMAC, is not a publicly traded company, so there was not a lot of impact there. Citigroup was another. It fell just short of the minimum capital ratio requirements when its plans for repurchasing shares and increasing the dividend were included. So, essentially the bank is going back to the well. They are going to have to rework their plans and submit a new one.

SunTrust Banks was another bank that failed. That was a little bit surprising. SunTrust had wanted to raises its dividend and look at share repurchases. Management felt like the Fed's assumptions regarding future loan losses were too aggressive for their circumstances. The bank would expect to fare better, but the regulators' word is a law there. And the final one was MetLife, which most of us think of as an insurance company because it is. But it became a bank holding company back during the crash, so it falls under this supervisory assessment regime. MetLife was also looking to raise their dividend and repurchase shares. The firm felt like the test was unfair; you kind of would expect management to say that. But in any event, MetLife won't be looking to increase cash returns to shareholders right now.

Glaser: So, let's take a look at the good news for the companies that did pass. What kind of dividend increases did you see, and were you surprised at the size of them?

Peters: Actually, what I was most surprised about was the fact that we didn't see as many dividend increases right out of the gate as we saw when we went through this process a year ago. Yesterday, out of the 19 banks, we had six of them issue dividend increases as State Street issued a dividend increase this morning. Three more talked about having gotten permission to raise dividends but hadn't actually gone ahead and declared a new dividend. So, those are kind of in the potential "maybe" file.

Overall, it wasn't quite as dramatic as what we saw a year ago, but the good news is that I think that the banks that I've considered for a long time as doing the best for dividend investors--BB&T, U.S. Bancorp, and Wells Fargo--those produced three of the four-largest percentage increases in their dividends and now have some of the highest yields in the group.

Glaser: And how big are those dividends now?

Peters: Well, BB&T raised its dividend from $0.16 a share a quarter to $0.20. I was only looking for $0.17. BB&T didn't cut its dividend as much during the crash, so it didn't have quite as much to recover from. I was very pleased to see that dividend go up 25%; it beat my expectations. U.S. Bancorp is another one that exceeded my expectations. I started out looking for about 40% dividend hike. I started to think I might be a little bit low, and in the end the bank come up with a 56% dividend hike to $0.195 a share on a quarterly basis. So, the yield on that stock is now back in the 2.5% type of range as is BB&T.

Wells Fargo was really the big percentage leader with an 83% increase in the dividend, going from $0.12 a share a quarter to $0.22. It also topped off the first-quarter dividend that it had already paid with an extra $0.10-per-share dividend that's going to be payable in the next couple of weeks. With these moves, you're seeing that these three banks in particular are using their financial strength and using the recovery and the increase in their earnings power to provide much better dividends.

Elsewhere, J.P. Morgan Chase was the first out of the gate, announcing a 20% dividend increase. Last year it had the biggest increase of all. I wasn't surprised to see its results a little bit more muted. But with this bank, we're seeing a much, much larger emphasis on share buybacks; J.P. Morgan talked about a $15 billion allocation to share repurchases for the rest of this year and through the first three months of next year. CEO Jamie Dimon is a very, very smart guy. I have all the respect in the world for him as an operator, but he said in the past he would just assume not even pay a dividend. He would rather be repurchasing shares with the bank's excess capital. When you put that together with a business model that's very complex there, with a lot of volatile revenue streams, in the investment banking, trading, and derivatives operations, I really don't think that it's still the best choice for people who are looking for dividend income among the banks. I think what BB&T, U.S. Bancorp, and Wells Fargo did yesterday really underscores that they are the best of the breed among the large banks for dividends.

Glaser: Looking forward after these big increases, do you expect dividend growth to be more muted in the future during the next couple of years, or could investors expect a nice pickup there as well?

Peters: Well, it's going to be really hard to expect the same kind of percentage increases going forward on an annual basis. I certainly wouldn't expect Wells to be able to raise its dividend 83% again next year. That becomes a huge number as the base moves up, but I don't think the recovery is all over yet. One of the features that we saw in the announcements even from the three best banks that I have been talking about is that they're still hewing to about a 30% payout ratio, and that's what our regulators have been guiding banks toward. They don't really want to see them go beyond that level. They want them to continue to accumulate capital because it is an uncertain world. We still have troubles in Europe, and there's still some uncertainty about the fate of the U.S. economy and when the residential real estate market will start to rebound. But I think during the next year or two, we're finally going to see that start to relax.

Wells and U.S. Bancorp have talked about wanting to bring their payout ratios more in the 30% to 40% range. So there is upside potential to the dividend rates on the basis of just the higher payout ratio. Also expect their earnings are going to continue to grow as loan losses shrink and as their balance sheets expand in an economy that seems to be getting better. Overall, I think, next year at this time, because this is now going to be an annual part of the industry's planning process, we could be looking at another round of, say, 20%-30% dividend increases from these banks. So, we've got a long, long way to go to be sure before we get back to where these dividends were before the crisis. And we'll probably never see payout ratios as high as they were back then; they are just going to be low going forward.

But I think that seeing these big dividend increases is reminding investors that that's what banks are in business to do from the standpoint of shareholders: pay good dividends and return capital to shareholders. U.S. Bank, for example, is also planning to buy back 100 million shares of its common stock. That's a little more than 5% of what's outstanding. So if the bank does that during the next 12 months, that should add 5 percentage points to whatever dividend increase we should be looking at a year from now. I like these stories. They are not terribly complicated. There is a lot of uncertainty. Regulatory scrutiny has gone up, but there's still a lot to appreciate. Banks need to function. They need to be profitable. They are important intermediaries in the economy. They're perhaps never going to as profitable as they were before the crash, but I think that they can still provide good total returns with a good cash component through the dividend going forward.

Glaser: Josh, I really appreciate you taking the time today.

Peters: Yes. Thank you, Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.