Four bankable stocks to profit from as interest rates rise

Recent rally has driven valuations up, but they remain attractive propositions.

Vikram Barhat 18 January, 2017 | 6:00PM
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Strength in the U.S. job market, a brighter economic outlook, rising consumer spending and the Federal Reserve's decision to start raising interest rates are indicators that conspire to create a tailwind for the U.S. banking sector.

Banks that have been working through performance issues now seem better positioned to benefit from future rate increases. Also, there is a widely held belief that the Trump administration will curtail a slew of regulations introduced in the aftermath of the 2008 financial crisis, improving prospects for the financial services industry.

In 2016, financial services was the second-best performing sector in the United States, not far behind energy. The S&P Banks Select Industry Index produced a total return of more than 31% over the calendar year, more than doubling the S&P 500's 12% total return. This strong performance has indeed led some of these bank stocks to trade above their fair value estimates. However, a closer look at their valuations reveals they are trading at price-to-earnings multiples that are still below industry and S&P 500 averages, indicating further upside potential.

With strong fundamentals, growth prospects and steadily rising dividends, the following bank stocks appear attractive propositions for this year's wish list. Investors may want to keep these stocks on their radar screen for any future corrective price drops.

U.S. Bancorp
Ticker USB
Current yield 2.07%
Forward P/E 13.3
Price US$51.69
Fair value US$49
Data as of Jan. 16, 2017

A diversified financial services provider,  U.S. Bancorp (USB) is the fifth-largest bank in the United States with branches in 25 states. Funded primarily by low-cost core deposits from the communities it serves, the company operates four profitable segments: wholesale and commercial real estate banking; consumer and small-business banking; wealth management and securities services; and payment services.

"Few domestic banks can match the operating performance of U.S. Bancorp since the financial turmoil of 2008-09," says a Morningstar report. "U.S. Bancorp's longstanding ability to post excess returns on capital is rooted in its superior credit underwriting, fee generation, strategically beneficial acquisitions and sound management."

The bank has carved out an impressive array of fee-based revenue streams from credit cards, wealth management and payments processing, which generates approximately half of total revenue. "U.S. Bancorp's payments processing business, which generally carries the payments between consumers and merchants, remains very lucrative, with a large number of merchants under contract," says Morningstar sector director Stephen Ellis.

The wide-moat bank's ability to generate excess capital gives Ellis confidence that it will continue to increase dividend payout. "Ideally, the company aims to return 60% to 80% of net income to shareholders in the form of dividends or share repurchases," he says. "This would be the icing on the cake for U.S. Bancorp, one of the best-run banks."

As well, the bank's efficiency ratio remains exceptionally low -- typically in the low 50s. A lower efficiency ratio means that a bank is operating better.

Wells Fargo & Co.
Ticker WFC
Current yield 2.74%
Forward P/E 11.8
Price US$55.31
Fair value US$62
Data as of Jan. 16, 2017

 Wells Fargo (WFC) is one of the four largest U.S. banks, rapidly approaching US$2 trillion in balance sheet assets. The company is split into three business segments: community banking; wholesale banking; and wealth, brokerage and retirement. It also has a dominant presence in the real estate market, servicing more than US$2 trillion in residential and commercial loans.

Wells Fargo is the largest deposit gatherer in major metropolitan markets across the country. "More than one third of the bank's deposits come from markets in which Wells Fargo is the pre-eminent player, and more than two thirds are gathered in markets in which the company ranks among the top three," says a Morningstar report.

The bank, of which nearly 10% is owned by Warren Buffett's  Berkshire Hathaway (BRK.B), is well-positioned to benefit from favourable macroeconomic tailwind. "The resumption of borrowing by U.S. consumers and businesses, the decline of emerging-market savings and the normalization of monetary policy will drive U.S. short-term rates above 2% by 2020, boosting net interest income," says Morningstar equity analyst Jim Sinegal.

With almost half of revenue coming from a diverse range of fee-generating businesses, though, Wells Fargo is relatively insulated from interest rate uncertainty. And while the recent controversy surrounding Wells Fargo shows the bank is not "without sin," such issues are "temporary and manageable," says Sinegal, who puts the stock's worth at US$62, above its current price.

Citigroup Inc.
Ticker C
Current yield 0.70%
Forward P/E 10.4
Price US$59.63
Fair value US$70
Data as of Jan. 16, 2017

A global financial-services company,  Citigroup (C) has operations in more than 160 countries. The company's core business consists of its global consumer banking segment and its investment banking group that serves institutional clients.

Citigroup has had its share of troubles, but its progress over the past five years is underappreciated. "The bank has raised capital, shed assets and bulked up its board of directors and management team with experienced bankers," says a Morningstar report. "The company has built an enviable capital position and maintains diversification without participating in an unmanageable number of businesses and geographies, dramatically reducing its fragility."

Sinegal asserts the bank, with complex operations spanning multiple continents, "is still too big to fail." Citigroup is more than just a domestic lender, and given its ability to provide a variety of services across borders, it should remain a bank of choice for global corporations. "Citigroup's truly global presence differentiates the bank from nearly all of its peers," says Sinegal, whose US$70 estimate of the stock's worth suggests more than 15% upside potential.

With significant revenue coming from Latin America and Asia, the bank is poised to ride the growth of these economies in the coming decade, without undue exposure to any particular country. "Developing economies should offer an attractive combination of high margins and rapid credit growth over time," says Sinegal. This, he notes, should allow investors to "sleep more soundly over the next decade."

JPMorgan Chase & Co.
Ticker JPM
Current yield 2.17%
Forward P/E 11.6
Price US$86.70
Fair value US$72
Data as of Jan. 16, 2017

 JPMorgan Chase (JPM) is one of the largest financial institutions in the U.S., with more than US$2 trillion in assets and operations in dozens of countries. The company operates several business segments including investment banking, commercial banking, treasury and securities services, asset management, retail financial services and credit card businesses.

"Customers are still flocking to the bank, and it is quickly generating capital," says a Morningstar report. "Its massive branch and ATM network, combined with exceptional customer service, draws deposits and contributes to economies of scale, while its top-notch investment bank and asset management operations boost revenue and increase customer switching costs."

The bank's sheer size has prompted some to call for it to be broken up, but, says Sinegal, "there are clear benefits to customers stemming from size," and it would be harder to meet "the needs of complex, global corporations" by a "smattering of smaller institutions."

However, he cautions that it's unreasonable to expect the firm to consistently fire on all cylinders. "Capital-markets-driven business, including trading, investment banking, and asset management, is cyclical, as is the firm's core lending business," says Sinegal. "So there are limits to the benefits of diversification."

That said, JPMorgan should generally command a valuation consistent with its position in a cyclical, slow-growing, heavily regulated industry. "The firm finally seems set to benefit from moderate loan growth, higher interest rates and margin, an improving housing market, and minimal loan losses after several years of industry-wide conservatism," he says.

Even in the event of a global market downturn, the long-term outlook for JPMorgan looks fairly bright, assures Sinegal.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Berkshire Hathaway Inc Class B361.34 USD-0.37Rating
Citigroup Inc45.08 USD-0.33Rating
JPMorgan Chase & Co153.19 USD-0.23Rating
U.S. Bancorp36.79 USD-1.10Rating
Wells Fargo & Co43.02 USD0.23Rating

About Author

Vikram Barhat

Vikram Barhat  A Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry, Vikram also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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