Dividend-Stock Deep Dive: Banks and Capital Allocation

Key Takeaways

• When you cut your dividend, it sends a negative signal to the market. Banks generally want to avoid that.
• The new excise tax on buybacks will have a minimal effect.

David Harrell: I'm David Harrell with Morningstar Investment Management, and I'm here today with Eric Compton, who is a strategist with Morningstar Equity Research, and he covers U.S. and Canadian banks.

Eric, thanks for being here.

Eric Compton: Great to be here.

Why Banks Cut Dividends

Harrell: I want to talk about banks and dividends today. So, obviously, banks pay out a fair amount in dividends to their shareholders. We have seen cuts in the past, particularly coming out of the 2008-09 financial crisis when all of the Big Four U.S. banks slashed their dividends. How common are cuts within the industry?

Compton: You brought up kind of the main example of when large cuts did occur. So, they are pretty uncommon. When you cut your dividend, it sends a pretty negative signal to the market. So, banks generally want to avoid that. A lot of shareholders count on those. You don't see it too often. When you typically see it is when banks need to preserve capital and are under a high amount of stress. And so, 2007-08 was a perfect example of that. A lot of the banks got walloped in ways that they weren't expecting. You saw dividend cuts throughout the industry. Actually, under my coverage, only two banks didn't cut their dividends. It was very widespread throughout the industry. That was really the last example of when it happened to that degree. Just to call out the pandemic in 2020, only one bank under my coverage cut their dividend, and you could argue it was slightly really due to the pandemic. It was Wells Fargo. They were going through some of their own unique issues. And so, it was slightly idiosyncratic. And so, even during the pandemic, you didn't really see a lot of dividend cuts in the industry. That happened back then. All the Big Four did it. But usually, you don't want to see that, and usually, you don't see it.

Capital-Allocation Plan Requirements

Harrell: Coming out of that financial crisis, though, we did see increased regulation in terms of the stress tests for banks and also the banks having to submit their capital-allocation plans to regulators for approval. Basically, they needed approval to raise a dividend, for example. Where do we stand today in terms of those regulations?

Compton: It's a really interesting question. A lot has actually changed over the last couple of years. Like you mentioned, there were a lot of changes coming out of 2007-08 where a lot of things had gone wrong for the banks. And so, the regulators wanted to make sure that something like that didn't happen again. They changed a lot of the regulations, required the banks to hold more capital. You had to get capital returns like dividends and share repurchases approved by the regulators now. And that's been the regulatory regime pretty much since then. And then, in 2020, we actually had a few changes. So, prior to 2020, the banks go through stress tests every year, and for the stress tests prior to 2020, the banks would submit a proposed capital return plan which would include dividends, for instance. And then, the regulators would run all these simulations, put the bank's plan under stress, and then see if in the simulation the bank would do well enough. If they did, then the regulars would approve that capital return plan. And so, like you just said, the banks had to get their actual capital return plans specifically approved by the regulators.

In 2020, that round of stress tests, they actually started a new technique called the stress capital buffer. And so, essentially what that means is, is the results of the stress test determine what they call the stress capital buffer is. And that's just part of your capital requirements. And so, if you do worse on the tests, the regulators are going to say, "Hey, you know, you seem to be a little more risky. We want you to hold more capital." If you do a little bit better on the test, the regulars say, "Hey, you're a little less risky. You can hold a little less capital." And then, once their capital target is in place, the capital target set by the regulators, after that, it's kind of up to the banks what they want to do to meet that target. And so, now they don't need to get the dividends specifically approved by regulators, but they plan their dividends now to meet that target. So, a little bit more flexibility, slightly different, but still a similar flavor of the regulators are still kind of there in the background as banks determine these things.

Stock Buybacks Offer Flexibility

Harrell: As we were saying, banks do return a fair amount of cash to shareholders as dividends. But looking at the overall industry, more cash is returned to shareholders via buybacks or repurchases. But Morningstar analysts think that's generally appropriate given the volatility of earnings within the within the industry, correct?

Compton: It's exactly like you just said. Buybacks tend to be more flexible. So, you can go to zero buybacks in a quarter. You can do 100% of your net income as buybacks in a quarter if you're looking to bring down capital levels a little bit because you've got excess capital, and the market is not going to interpret that in such a strong way as if you try to adjust your dividend.

Harrell: Right. You get punished for a dividend cut but not for reducing buybacks.

Compton: Exactly. Generally, the typical bank capital allocation plan, you've got 30% to 40% of net income allocated to dividends. After that, then the preference is they want to invest in the business, invest for growth. And then, whatever is leftover depending on capital requirements, et cetera, kind of one of the main levers of release there would be share repurchases. And so, quarter to quarter they'll make decisions about that, how many share repurchase they want to do. And like you said, it's a nice way to do it because it is flexible.

New Excise Tax on Stock Buybacks

Harrell: I have to ask just because it's in the news. So, the Inflation Reduction Act that was just signed contained a new 1% excise tax on buybacks. So, firms would pay that tax on their net repurchases within a fiscal year. What effect, if any, do you think this is going to have on how banks allocate their capital?

Compton: I think it will actually have a pretty minimal effect. From the banks' perspective, as they think about what shareholders value, on the margin there might be a slight change in decision, but it's going to be really minor and on the margin for the most part. It's essentially just a tax on the shareholders. So, banks, they will earn income. They pay out a portion of that income as dividend. That goes to shareholders. Shareholders own that dividend income, but then the price of the stock will generally go down by however much they paid out because the company doesn't own that cash anymore. Now, it's the shareholder. Shareholder gets taxed on that.

One of the more efficient ways of doing it in the past was you do buybacks. So, in that case, you only get taxed on the capital gain once you sell the stock. Now, that cash essentially has an extra 1% tax on it. And so, the shareholders, they are going to get 1% less of that value back whenever those share repurchases occur. So, I don't anticipate any major changes in bank behavior, and just the shareholders will be just 1% less well off.

Bank Stock Picks

Harrell: Looking at the industry right now what are some of your current picks both from a valuation and current yield or potential for dividend-growth standpoint?

Compton: I'll start with the Big Four. So, within the Big Four, you could say I have a little bit more of a value tilt. So, at Morningstar, we do long-term fundamental valuation. Based on that, Citigroup looks the cheapest to me right now. I think it's safe to characterize that one as more of a deep-value play. Plenty of issues with Citigroup. There's a reason they're cheap.

Harrell: Right. The share prices never recovered from the dilution that occurred a decade ago.

Compton: Right, exactly. Shareholders have never been made whole from pre-2007. And they're still dealing with trying to turn the bank around and some of those issues. And so, all that said, I still think the price is just too cheap. I think the bar is so low. Even when I'm doing what I consider to be fairly conservative projections, I think they can exceed that low bar. So, I've got them at greater than 30% undervalued right now. As a result, they have the highest dividend yield among the Big Four. Valuations, dividend yields tend to be fairly correlated. So, I think Citigroup is the cheapest. And then, I think JPMorgan and Wells Fargo are kind of tied for second-cheapest among the Big Four, closer to like 20% undervalued, so not quite as cheap as Citigroup.

As far as dividend growth among the Big Four, it's interesting because a key theme in the banks right now is that capital requirements are actually going up. And so, after the latest round of stress tests, that stress capital buffer requirement actually went up for JPMorgan, Bank of America, and Citigroup. It didn't go up quite as much for Wells Fargo, and you also have some changing G-SIB buffer requirements. And so, because capital requirements are going up so much for JPMorgan and Citigroup, I think their dividend growth is actually going to be more limited than Bank of America and Wells Fargo. And Wells Fargo, I think, will actually have the highest dividend growth among the Big Four. So, that's how I would rank them.

And then, among the regionals, there's a bank called KeyCorp or KeyBank. And they're the cheapest regional bank I cover, second-highest dividend yield, and they are midsize regional. They've got a presence in the Northeast and the Northwest. A little bit more investment banking exposure. So, I think that's why they're a little bit cheaper right now because that industry is kind of hitting some cyclical lows at this point. But otherwise, I think a decently run regional. We like what they're doing on the consumer side, particularly in certain expansion efforts. So, I think a good dividend yield, a fairly cheap stock among the regionals that I would call out as well.

Harrell: I just wanted to hop back to Wells Fargo, which you mentioned at the beginning had a dividend cut back in 2020, I believe. They went from, I think, $0.51 per share per quarter down to $0.10. And they've been regrowing the dividend since that, and I think with the most recent increase they are back to $0.30 per share per quarter. And I think you had said previously that you see them getting up to $0.40 per share maybe by 2023.

Compton: Exactly. Exactly right. As we mentioned before, Wells had to cut their dividend during the pandemic. Part of it was that the regulators put more stringent payout limitations. And so, Wells was going to exceed those. And so, they were kind of, you could say, forced into a dividend cut on one hand. However, as you can see, even with those restrictions now lifted, their dividend has not recovered to what it was prepandemic. And so, part of it was the pandemic, but part of it was also just Wells. Their profitability was going to take a hit no matter what, and the dividend was structurally too high. We see the dividend recovering. They actually have the fastest dividend growth in our projections among the Big Four. Still not quite getting back to what it was prepandemic, like you mentioned, like, $0.40 versus $0.51 and the $0.40 not until 2023. So, good growth there, not quite back to where they were, still a work in progress. But, yeah, a good one to call out.

Harrell: Good. That's great, Eric. Thanks for sharing your insights and being here today.

Compton: Absolutely. It was great to be here.

Harrell: I'm David Harrell with Morningstar Investment Management. Thanks for watching.

Watch "3 Dividend Stocks for September 2022" from David Harrell.