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By Jeremy Glaser | 04-21-2011 11:54 AM

Banks Not a Good Dividend Bet

With bank dividends trickling back and growth nowhere to be seen, income investors are better off looking elsewhere for income, says Morningstar's Josh Peters.

Jeremy Glaser: For I'm Jeremy Glaser. Banks and dividend investors have had somewhat of a rocky relationship over the past few years. I'm here today with Josh Peters, editor of Morningstar DividendInvestor, to see what income seekers can expect from banks going forward.

Josh, thanks for joining me today.

Josh Peters: Good to be here today.

Glaser: So, we talked a couple of weeks ago about how banks were finally allowed to start to raise their dividend, and we saw some big bank earnings come out this week. What have you learned about the banks' new philosophy about paying back shareholders?

Peters: Well, I mean the biggest sign that you're going to get was just that first move to raise the dividends, after they had been slashed in 2008 and 2009 and been flat at very low levels up until March. So, I mean that in terms of signaling, just getting the dividend moving again and moving in the right direction, that was huge. That was sort of the first of what we hoped for would be a long-awaited payoff for bank shareholders. I mean you described it as a rocky relationship. With "rocky" there were potholes the size of small states regarding what most bank dividend investors have had to live with.

So, now we're moving into earnings season. We've seen a lot of largest banks already report, including the three that I hold as part of our Dividend Builder model portfolio, where we look for a lot of dividend growth and good yields. In the initial picture, you still got the dividend increases; earnings are improving as credit costs come down. But the story has kind of changing. I am not a guy that spends a lot of time worrying about short-term stock price movements and how the people on CNBC and trading floors are going to react, but I can kind of understand why maybe investors are less enthusiastic about the banks. There is just not a whole lot of growth potential now.

Glaser: So, what's holding back the growth in these bank stocks?

Peters: Well, I think you got to look at it in a little bit longer perspective; roll back to the crash. Wells Fargo was trading at $9. Just having that bank and most of the big banks in the country survive this panic circumstance we were dealing with, you got a triple out of Wells Fargo in fairly short order from those kind of panicky bottoms.

Then you move into the phase of what does the long-term normalized earning power look like for these banks. Current earnings are being depressed by very high charge-offs, but once you've written off pretty much everything you have to from the old bad loans, then your costs drop and your earnings expand and that's really how you want to think about valuing these stocks on a long-term basis.

So, I think people, even last year were getting pretty comfortable with what the long-term earning power was going to look like, especially, for bank like Wells Fargo and to a lesser extent U.S. Bancorp. They really did a fantastic job of leveraging the financial strength that they had preserved through the crisis to make some acquisitions and bulk up their future earning power, and also offset some of the dilution that was associated with issuing new shares, the TARP program, and all the rest of those things.

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