Investment Contrarians

Bank Stocks at Crucial Crossroads

By for Investment Contrarians |

Bank Stocks at Crucial CrossroadsLast year was a great year to be an investor in bank stocks. We’ve seen a dramatic rebound in the price of most major bank stocks in America as the earnings outlook has improved. Clearly, the earnings outlook at the beginning of last year was far too pessimistic for the majority of bank stocks.

The question: what’s in store for bank stocks in 2013?

Wells Fargo & Company (NYSE/WFC) just released its earnings numbers, and they were very strong, as the firm reported a 24% jump to $5.1 billion in profit for the fourth quarter of 2012 from the year-ago period. For the full year, the company had record income of $18.9 billion, up 19% from 2011. (Source: “Wells Fargo reports record full-year in quarterly net income,” Wells Fargo & Company, January 11, 2013.)

An area of concern is that the net interest margin was down to 3.56%, from 3.89% the previous year. This is the difference between the rate it charges borrowers and the interest it pays depositors.

Refinancing of mortgages accounted for approximately 75% of the total revenue. Clearly, the lower rates that the Federal Reserve has engineered have encouraged a large number of homeowners to refinance, freeing up excess funds to use in other ways.

However, while it seems a great time to be invested in bank stocks, the earnings outlook might be a bit more complicated. The big problem for bank stocks is that they are not able to find enough places to lend in comparison to the massive inflow of deposits.

Bank stocks currently hold $10.6 trillion in deposits at the end of 2012. This is an all-time record-high, according to Market Rates Insight Inc. Conversely, loans outstanding declined 5.3% since 2008. (Source: “Wads of Cash Squeeze Bank Margins,” Wall Street Journal, January 11, 2013.)

According to SNL Financial, bank stocks loan-to-deposit ratio was 72% in the third quarter of 2012, down from 95% in 2007. The loan-to-deposit ratio is the level of lending versus the amount of funds taken in from depositors. This should be close to 100% for the earnings outlook to be extremely positive for bank stocks. (Source: Wall Street Journal, January 11, 2013.)

This is a double-edged sword for bank stocks, as they are limiting loans to only the very highest of credit-worthy clients, which is a positive in terms of overall quality, but the total transacted is not keeping pace with deposits.

As a shareholder in bank stocks, this means the assets on their books are very high in quality, but the total number of new loans is low in relation to the deposits on hand, which will lower the earnings outlook.

With approximately three-quarters of Wells Fargo’s revenue stemming from mortgage refinancing, this means two things: 1) the assets on its book are very high in quality since only the top credit-worthy clients are able to get new loans and refinancing; and 2) once the Federal Reserve stops its asset purchase program and eventually raises interest rates, the refinancing boom will end, harming Wells Fargo’s earnings outlook.

This really is a double-edged sword for bank stocks. On the one hand, bank stocks are extremely strong in terms of capital allocation ratios and the quality of their assets; on the other hand, the earnings outlook begins to look questionable due to the lack of demand and tight policies regarding who is able to obtain loans and mortgages.

WFC Wells Fargo & Co. stock market chart

Chart courtesy of www.StockCharts.com

In my opinion, of the large bank stocks, Wells Fargo is the best. This also means that it’s not the cheapest of the bank stocks. Because of its reputation as being one of the top bank stocks, the stock trades at a premium-to-book value of 1.3. The best time to buy bank stocks is when they are trading at a discount-to-book value and the earnings outlook misjudges the environment.

Clearly, this is not the case for Wells Fargo, as many investors have properly calculated that this firm would have a strong 2012. For the long-term holder in bank stocks, the assets that the company has on its books are now quite strong considering its tight lending standards. For the short-term investor, bank stocks might have trouble at the end of this year or next year when the Federal Reserve starts to pull back on the monetary stimulus program. After such a strong run, I will surely be taking some profits off the table.

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