Time to Buy Big Banks?
We think the pessimism regarding the large U.S. banks is overdone.
We believe the market is overly fearful about the prospects for large U.S. banks following fourth-quarter earnings reports. Energy exposure is limited, especially relative to exceptionally high capital levels. In the 1980s, nonperforming loans at oil banks peaked above 10% of total loans--none of the country's largest banks have energy exposure anywhere near this level. We remain bullish on the prospects for housing in the medium term as millennials age, especially if the employment market remains strong and mortgage credit becomes easier to obtain.
Citigroup remains a best idea on valuation, trading at a substantial discount to our $68 fair value estimate and its $60.61 tangible book value per share. Bank of America once again looks attractive as well, and we see it as best positioned to benefit from a rebounding U.S. consumer as well as eventual rising rates. Wide-moat Wells Fargo is likely to be the least volatile of the large banks, with its minimal exposure to capital markets businesses.
We see a persistent low inflation environment as the biggest risk to the banks, as the interest rate environment has been arguably the largest headwind over the past few years.
Narrow-moat Citigroup produced $17.2 billion in net income in 2015 versus a current market capitalization of roughly $125 billion. Despite headwinds, we think the stock is quite cheap at current levels even if earnings significantly deteriorate from here. We also think the company is now well positioned to endure any downturn, in contrast to its position in 2008. With a 12% common equity Tier 1 capital ratio ($146.9 billion in capital), a 7.1% supplementary leverage ratio, $12.6 billion in loan-loss reserves, and few esoteric assets, Citigroup will handily weather the storm in emerging markets, in our opinion.
Management believes lower oil prices are benefiting consumers there in a manner similar to the United States, although corporate credit in the energy sector is clearly deteriorating. Furthermore, Citigroup's focus on prime customers internationally appears to be providing a buffer against losses. Net credit losses in the company's consumer businesses actually fell from $1.7 billion to $1.5 billion over the past 12 months. Past-due consumer loans in Latin America--dominated by Mexico--have fallen over the past 12 months, as have delinquent consumer loans in Asia. A bigger concern is the decline of revenue in both of these regions. We expect competition to shrink spreads in developed markets over time, but falling benchmark rates have no doubt contributed, as have reduced consumer risk appetites in weakening economies. We don't see these trends reversing in the short run, but think Citigroup's diversification will mute the impact.
Citigroup's institutional client group reported revenue growth across most categories during the year, thanks in part to good results in rates and currencies and better conditions for credit trading. Core expenses in this segment also fell slightly from 2014. We think volatility could have a deleterious effect in 2016 after several years of fairly benign conditions in capital markets.
Citigroup took $724 million in legal and repositioning costs during the fourth quarter. We think systemically important institutions will be an easy target for years to come, and we are reminded of Citigroup's legal charges in the years before the financial crisis. The company's aggressive restructuring--including efforts to reduce noncore and low-return assets and improve efficiency--is also likely to keep certain costs running high for some time.
Bank of America (BAC)
After more than a year around our $17 fair value estimate, narrow-moat Bank of America shares are becoming attractive. The stock is trading at a discount to both our fair value estimate and its $15.62 tangible book value per share even as performance has improved. In the medium term, we think a steadily improving U.S. housing market will offset headwinds in commercial lending (specifically a crashing energy market), contributing to consumer business growth and the eventual elimination of more than $1 billion per quarter in spending related to crisis-era assets. More important, funded energy exposure of $21 billion makes up only a fraction of the bank's $154 billion in common equity Tier 1 capital.
That said, the coming year could see slower improvements as energy credit takes a toll on results, especially if capital markets continue with recent downtrends. Investment banking fees and trading account profits produced seasonally low revenue, though Bank of America navigated the trading environment well. Not surprisingly, volatile markets were accompanied by lower client trading activity, though long-term assets under management continued to experience positive flows, and the company continued to add financial advisors.
As we've long cautioned, the path to normalized interest rates may not be smooth, and developments over the past few months reinforce this opinion. Not only are commodity and emerging-market troubles likely to hold back the Federal Reserve, but we expect rising rates to follow an improving housing market rather than the inverse. We're encouraged by rising consumer demand for other forms of credit--Bank of America increased credit card as well as auto loan balances during the quarter--and we model a 40-basis-point increase in net interest margin over the next five years.
Wells Fargo (WFC)
Wells Fargo's WFC fourth-quarter and full-year results were entirely in line with our expectations, and we are maintaining our $61 fair value estimate for the wide-moat bank. The company produced a return on tangible common equity of approximately 16% over both periods--an impressive return in the current environment.
Low rates, as expected, continued to have an effect on revenue. The net interest margin fell 4 basis points as the company continued to gather deposits and loan yields fell. However, we were encouraged by loan growth across numerous categories, both business and consumer. We think rising demand for credit and a rebound in the U.S. housing market driven by demographic and economic factors are quite likely to result in a normalization of the interest rate environment by the end of our five-year forecast period.
Wells Fargo's total noninterest expenses fell slightly from the fourth quarter of 2014, but management expects the company's efficiency ratio to approach 59% in 2016, up from 57.8% in 2015 and at the high end of its goals. The company attributes this to higher spending on compliance, risk management, and technology. Though these expenses will hurt profitability over the short run, we think Wells Fargo and its massive peers will eventually benefit from economies of scale in these areas. Smaller banks will simply not be able to match the spending of the money centers in these areas over time and could lose share as a result.
The collapse of the oil and gas market began to take a toll on earnings as Wells Fargo charged off $118 million of these loans, quadrupling from the linked quarter. Provisioning for loan losses rose to $831 million, matching total charge-offs. We see little reason to be concerned, however. Energy lending makes up only a small percentage of the bank's total portfolio, and our valuation incorporates a significantly higher level of normalized charge-offs, which remain at record lows.
Though Wells Fargo has less relative exposure to the capital markets than some of its large peers, the company was not immune from recent volatility. Managed assets in the retail brokerage fell slightly from the end of 2014 on market movements, as did assets under management and retirement plan balances. We would not be surprised to see a tough year in 2016 after a long period of strong stock market performance.
We like that the company reduced shares outstanding by about 1.5% over the past 12 months. We expect Wells Fargo to pay out approximately 75%-80% of earnings by 2020.
JPMorgan Chase (JPM)
Narrow-moat JPMorgan Chase's JPM results included little to change our opinion, and we raised our fair value estimate to $66 per share from $64 to account for the time value of money since our previous update.
Through reductions in nonoperating deposits, Level 3 assets, and over-the-counter derivative notional balances, the company believes it will qualify for lower regulatory capital buffers, reducing a potential disadvantage to peers able to operate in similar business lines with lower capital levels. We expected JPMorgan to take action on this front and model it operating near current capital levels (Basel III Tier 1 capital of 11.6%) over the next five years; should the company need to operate with a larger buffer, we'd reduce our fair value estimate.
Worries in the capital markets detracted from performance in multiple areas, and the near term may continue to be difficult, but we expect volatility in trading, investment banking, and asset management revenue and will not alter our fair value estimate as a result. The company saw net outflows in asset management, a 34% decline in principal transactions from the third quarter, and a slight decline in investment banking fees.
Management believes the firm can reduce expenses in consumer banking by another $1 billion annually and another $1.5 billion in the corporate and investment bank, with a portion of these savings to be reinvested rather than passed on fully to the bottom line. Our valuation incorporates total noninterest expenses falling by approximately $900 million in 2016 and growing approximately 2.5% annually thereafter.
Not surprisingly, the energy and materials sectors are resulting in growing credit expenses for JPMorgan, including a $1.04 billion provision for credit losses in the quarter. Overall, though, we are positive on the medium-term outlook for credit. A low unemployment rate, the aging of the millennial population, and easing mortgage credit should be quite positive for the overall U.S. economy.
The branch business model is clearly changing, and JPMorgan is responding. Branch count fell from 5,602 at the end of 2014 to 5,413 in 2015, in sharp contrast to past plans to expand the footprint. However, we think this could actually be a positive for the country's largest banks, as economies of scale allow JPMorgan and its peers to roll out better technological solutions at lower cost. In fact, active mobile customers grew 19% even as the bank reduced its physical presence.
JPMorgan's efforts in the payment space will take time to play out. Spending and processing volume remains quite healthy. Merchant processing and transaction volume grew 12% and 14% during the year, respectively, and with a massive consumer and merchant presence, the company has numerous options to participate in the changing payment market.
However, management seemed to agree with our belief that growing merchant power will result in intense competition in the co-branding space, and its intent to defend its positioning does not bode well for other issuers.
Jim Sinegal does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.