Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Federal Reserve recently completed its review of the big banks' capital plans. I'm here with Josh Peters, editor of Morningstar DividendInvestor, to take a look at the future of financial services' dividend payments and what it could mean for investors.
Josh, thanks for joining me.
Josh Peters: Good to be here, Jeremy.
Glaser: We've done this a few times, now, where the big banks have to submit a capital plan [detailing] what they want to do with dividends or share buybacks over the course of the year for review by the regulators. Were there any big surprises this year, or did it shake out about as you expected.
Peters: There was one and kind of big downside surprise, though it's not going to affect many people who are holding the stock for income. Citigroup's plan was rejected again; I believe this is the second time in three years that their plans have been rejected. It wasn't that their overall financial position seemed so bad, but the Fed objected to more qualitative concerns, in particular some problems that the Citi has had in managing its operations in Mexico.
Citi I think wants to pay higher dividends, wants to be able to repurchase more shares, but regulators have a lot more power now that there are those muscles that they are willing to flex to a much greater degree than in the past to prevent banks from paying out more cash to shareholders, if they don't feel like the bank is being run safely and appropriately.
On the other side of the spectrum--it didn’t get as much notice perhaps because it wasn’t the big percentage move that you saw from some other banks--but I was just delighted by the 17% dividend increase that was issued by Wells Fargo. Wells is actually the only bank that I own now. A of number years ago, I think at one point I owned as many as eight different banks. Over time, some of them I had sold before the crash; others I held through and suffered dividend cuts.
Wells has now come all the way back; their new dividend rate at $0.35 a quarter starting here in the second quarter is actually a $0.01 higher than what they paid during 2008 at the peak level. And this really reflects the strength of the bank's basic business model. It's a very large but very simple organization for the most part that takes low-cost deposits and makes loans and collects the spread. And does very well without having to get deep into investment banking and trading or wide-ranging foreign operations in order to try to grow.
And with that dividend increase, Wells cemented its position as the highest-yielding of the big banks, up around 2.8% right now thanks to that increase.
Glaser: You mentioned that you only hold one bank now. Do these regulatory exercises and these potential headwinds to dividend growth now that banks will be constrained mean that it's unlikely that income investors are going to be finding any values in financial services? Does this process really mean that you should look elsewhere for income.
Peters: I think for value investors who are more agnostic toward income or the forms of shareholder return, whether it's dividends or buybacks, you can still look at banks, you can still potentially find some with more attractive stories. Certainly over the next couple of years you would hope that once short-term interest rates start moving up that bank earnings will start to improve. Their net interest margins will get wider.
And that’s something that all else being equal, I'd like to participate in, and I do get some of that participation with Wells. But the fact of the matter is that yields are just pretty low across the spectrum from these larger banks. Other than Wells, JPMorgan also raised its dividend; it was only about 5% increase. It yields in the mid-2% range, and then things start to run off pretty quickly from there to where as a group the CCAR participants yield less than 2%. And that is really a testament to the fact the regulators are still holding the reins back on capital that a lot of the banks are not as profitable as they used to be, especially in terms of return on equity. They’ve had to become less leveraged and carry more capital; that's constrained their ability to pass capital back to shareholders as they grow.
I'd like to think at some point that you'll see payout ratios move up somewhat from here, and perhaps we'll have the opportunity to look at a wider cast of names that could yield say in that 3% area. But one of the big lessons from the precrash era is that those banks shouldn't have been paying out 50% of earnings. That did leave them vulnerable to having to cut their dividends in a downturn. And unless they pay out that much of earnings going forward, this might just be a low-yield and frankly possibly lower-return sector than you would have considered it to be under the business models and financial models prior to the crash.
Glaser: You don’t expect that the Fed is going to allow the banks to really very much increase their payout ratios in a rising-rate environment where their earnings do look a lot better?
Peters: Well, there is interplay between capital and earnings. If you have a bank that has a really, really generous layer of capital on its balance sheet and it's really excessively overcapitalized, I think then regulators might not have so much of a problem with the bank moving into say 40% of earnings maybe even as much as 50% of earnings for dividend payout in the future.
That said, for the time being, some banks that I think could afford to pay higher payout ratios, more generous dividends, are choosing not to. For Wells to raise its dividend 17% as it did it had a breakthrough that 30% payout ratio cap that regulators had really been holding the line on here up until this year. The formal language is they apply extra close scrutiny to any plans for a payout ratio higher than 30%. While Wells pushed it up to 33%-34%. They've shown that their business model is strong enough, and diverse enough, well-capitalized enough to support that higher payout, and I think Wells will probably continue to try to nudge the payout up toward the 40% range over the next couple of years.
U.S. Bancorp on the other hand, which is a very conservative and well-run institution in its own right and a stock that I held for a number of years, up until just recently, they only raised their dividend about 6.5%, and they wanted to stay below that 30% cap. They weren't going to be like Wells and try to see if they could move past that.
U.S. Bank has frankly tilted its preference, I think not just because of regulatory pressure but just on their own account, toward wanting to spend more on share buybacks as opposed to dividends.
Now that's fine for the shareholders who appreciate that, but I never look at buybacks as being a substitute or a surrogate for a good dividend check. As a supplement, that helps the dividend grow faster over time because there are fewer shares outstanding. That’s fine. But with U.S. Bank only yielding around the market average down in the low 2% area, I think it's hard to make a case to own that stock for income. People could find other reasons to like it. But it's not distinguishing itself on the basis of its dividend prospects anymore.
Glaser: It sounds like Wells Fargo remains your favorite bank pick, then.
Peters: Favorite bank, only bank right now. I look forward to eventually perhaps having some more opportunities in this area. I don't think you need them. They don't need to be a piece of a higher-income portfolio. You've got other sectors, industrials, consumer staples, energy where you can put together a fairly well-diversified portfolio from an income perspective and you don't have to have exposure to some of the areas where you're not getting the required amount of income.
Glaser: Josh, thanks for sharing your thoughts today.
Peters: Thank you, too, Jeremy.
Glaser: From Morningstar I am Jeremy Glaser.
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