Banks Not a Good Dividend Bet

Jeremy Glaser: For Morningstar.com 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.

<TRANSCRIPT>

Then later last year, we had the dividend story, which is the Fed finally providing guidance, looking to relax its iron grip on bank capital. And in the fourth quarter, we actually had pretty good run for bank stocks.

Then you roll into this year, and you get the dividend story. You are seeing credit cost come down, not as fast as I think everybody would like, but they are coming down. But the situation is kind of changing. Wall Street in the short term is always looking for a catalyst--what's going to make a big pile of money in a big hurry. But the banks don't really seem to offer that.

The dividend story--people have moved to pretty much price in the normalized earnings power that a couple of years out these banks are likely to provide. But that earning power is not growing, and the reason is pretty simple: People just don't seem to want to borrow money. And unless bank balance sheets are growing, it's going to be very tough for other sorts of initiatives that banks might try to take, like say buying back shares or making acquisitions to really drive a lot of additional value creation and share-price potential for the bank stocks.

Glaser: So, we don't see a lot of growth due to a lack of demand for loans. Is there a yield story then?

Peters: Well, this is another area that is not looking as well as I would have hoped back during the crash and in that initial recovery phase. I mean take BB&T for example. Historically they had targeted a 40%-60% payout ratio for dividends alone and maybe be closer to the bottom end of that in the really good years, the top end in a weaker year because of higher credit costs. But more of less half of earnings were going back the shareholders as dividends and then perhaps a share buyback on top of that.

U.S. Bank had an even more aggressive policy, with 80% of its total earnings for dividends and share buybacks, with maybe two thirds of that total payout taking the form of cash dividends. That made them very attractive from a yield standpoint, but looking forward, what we're hearing is that payout ratios are going to be maybe more in the 30% area. That's what Wells is talking about; that's what U.S. Bank is talking about 30% or 35%.

The initial dividend raises from those banks are even short of that level. I am optimistic that perhaps we'll be looking at some second round of dividend increases in the second half of this year. I think that's certainly within their ability to do, and it's becoming more and more necessary as we are not really seeing a whole lot of growth.

And even think of BB&T, which has always had a really, really strong devotion to dividends, partly because their shareholder base is much more individual investors than it is institutions, and individuals, like me and my subscribers, really like to get those dividends. BB&T's now talking about a 30%-50% payout ratio, so they've taken their peg down a notch.

So, in all it kind of creates a little bit of a conundrum. If you are looking at these stocks through that short- to even intermediate-term lens--I think I am not getting a whole lot of yield, 2% or less, in the case of where the stocks are right now, but I am not really getting a whole lot of growth in that normalized earning power--the actual earning should continue to improve. But people are already assuming that; that's already in the stock prices.

Glaser: So, what should a dividend investor do then?

Peters: Well, I guess I can speak to from my own experience, which is, I've been waiting. I've been patient. I've been looking at these stocks and saying, what is that normalized earning power if I take these new payout ratios, even though they are lower, and apply them to that earnings power. What kind of dividend yield could I be getting, two three years from now, relative to where the stock is trading for right now? And then I have to compare that to the rest of the universe that I have to pick from.

And to me there is really no question that these banks have some of the best dividend-growth potential because of the improvement of actual earnings up into that normalized territory and because of the additional upside to payout ratios. And I think that for a long-term investor that still gives you some reason to continue holding these stocks. But I am much less likely to recommend buying them at this point just because I think there are better deals in defensive sectors. Look at, say, a Procter & Gamble or an American Electric Power or an Abbott Laboratories. These don't have the earnings upside potential because there is really nothing wrong with them; they are not trying recover from anything. They have very good yields and very good growth potential relative to their yields. That's why I think there is more value relative to where different companies within sectors are trading these days.

Glaser: Josh, thanks for the update.

Peters: This is just a story that never wants to make that final jump into, "Finally, I am being rewarded for my patience." But I think that there is still some reason to at least continue holding on them.

Glaser: Thanks again, Josh.

Peters: Thanks.

Glaser: For Morningstar.com, I'm Jeremy Glaser.