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By Jeremy Glaser and Josh Peters, CFA | 03-19-2013 02:00 PM

Wells Fargo Still Top Bank Stock for Income Investors

Josh Peters discusses the Fed stress test's implications for bank dividends with markets editor Jeremy Glaser.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He is editor of Morningstar DividendInvestor. He is also our director of equity-income strategy. We're going to take a look at bank dividends and see if the recent Fed stress tests have opened up any opportunities for income investors. Josh, thanks for talking with me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, the Federal Reserve recently released their annual assessment of what they think of bank capital levels, what kind of dividends they think the banks are able to pay. What does this report show? Were there any surprises in there?

Peters: There was only real one surprise at the back end of the process, and that was when BB&T, a very well-regarded bank that I actually used to own in one of my two model portfolios in DividendInvestor, was denied permission to raise its dividend. And the Fed said that essentially it was based on a qualitative assessment. Nobody wants to give any official details, but it looks like perhaps regulators weren't too happy with perhaps some mistakes that BB&T had made in terms of some of its accounting.

Other than that, I don't think people were too surprised by the results. I was especially pleased by Wells Fargo, which is one of the two banks I still own, coming on actually raising its dividend for a second time this year, and now the stock yields more than 3%. So, this is the first of my banks to really kind of break back out into really attractive yield territory since before the crash.

Glaser: This had been a big question, not if the banks should have--first, if the banks have the ability to increase, but if the regulators would allow them to. Do we have any more sense of what the regulatory environment is going to look like in terms of allowing these banks to return a significant amount of capital to shareholders?

Peters: Well, there's two dimensions to it; there's the buyback piece and the dividend piece. With Wells Fargo, if you run the numbers, it looks like the payout ratio that they'll have for this year is going to be a little over 30% maybe, and that has been the guidance that the Fed and regulators have talked about--sort of a 30% ceiling on payout ratios for these larger banks. So maybe we are starting to see them move a little bit beyond that, start to relax the reins. But the buyback piece is much easier for the banks to turn off or for regulators essentially cut off if things are to get unpleasant out there, and so we saw lots of big buyback authorizations.

In the case of U.S. Bancorp, the other bank stock I own, they're actually probably going to spend more on buybacks this year than dividends. And historically, I mean, this was a bank that was totally devoted to dividends. They had one of the highest payout ratios in the group, but I think that they felt kind of burned by the fact that they had to cut the dividend during the crash and maybe they don't want to bring it back as strongly as they did before. Problem is, I just don't think people value these buybacks as much as they do that steady cash dividend every quarter, so it creates something of a problem.

Glaser: So at 3%, then, is Wells Fargo attractive to income investors? Is there going to be enough growth there to make that worthwhile?

Peters: I think so, but I think what works for Wells is kind of an outlier in terms of performance--you can't really generalize. They are really, as far as I'm concerned, the best bank in the country. It's very, very large. They have all those terrific economies of scale. They have great management. But it's a still pretty simple business model. It's not about being heavy into derivatives or investment banking or trading. It's pretty much a plain-vanilla lending model. They do very well in terms of consumer cross-selling. It's just a great bank. And now that we see that yield over 3%, we still think that there is still upside in the shares' valuation from here. I'm looking certainly for dividend growth to slow down now that the dividend has recovered most of what was taken away during the crash. But I think you could still see the dividend rising 8%-10% here over the longer run.

A little bit harder, I think, when you look at some of the other banks to be comfortable with their risk profiles, like say the more investing banking-heavy names, like J.P. Morgan. They also raised their dividend, but maybe regulators are not quite as happy with the capital plans, quite as approving of those capital plans elsewhere. So the list of names to pick from certainly isn't as long as it was back before the crash. But I think one of the best observations from the stress test is just how strong our banks are now. They've built a tremendous amount of capital, they have become less risky, they're less leveraged, they are--whatever you think of government regulation--there is certainly more oversight of their activities now. I think it's a less risky place, with a name like Wells Fargo, to be investing for dividends going forward than it proved to be over, say, the last 5 or 10 years.

Glaser: So it doesn't sound like as a group, the banks are going to be the kind of income generators and dividend generators that they were before the crash?

Peters: Probably not, probably not anytime soon, because less leverage means they are less risky, but it also means they are less profitable. It means they have to retain more earnings in order to grow their capital base as well as their loan books. By the way, growth is kind of hard to come by, and interest rates are compressing their revenues, their net interest margins. It's not the greatest story out there, but I still think you can do well with Wells Fargo. In other cases, probably we'd be looking to another sector, but Wells is the one name I'm comfortable recommending now.

Glaser: Josh, thanks for your thoughts today.

Peters: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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