Where We See Bargains in the Banking Sector

Eric Compton: 2018 was a great year for the U.S. banking sector operationally, but a terrible year from a stock performance perspective. We started out bearish on banks in 2018, with valuations seemingly pricing in perfection, and bargains were tough to find, however to start out 2019 we feel valuations have become much more reasonable, and we are even beginning to see some bargains.

From a sector perspective, we see one or two more rate hikes likely occurring in 2019, and we are forecasting 2019 to be the last year of material net interest margin expansion. After this, we see rising deposit costs and a slowing rate hike schedule bringing an end to the current NIM expansion cycle. We also still see some excess regulatory capital in the sector, as well as a likely continuation of the strong cost control we saw in 2018.

The remaining NIM expansion, continued cost control, and the release of excess capital should roughly balance out the beginning of a normalization of the credit cycle, and as such, we don't see returns on equity sustainably expanding from here on out. We do expect credit costs to normalize over the medium term, as it appears we are in the later stages of the current cycle, however we don't believe this necessarily means that we are on the verge of another 2008 style downturn for the sector.

From a stock perspective, valuations have become much more attractive, and we view Wells Fargo and KeyCorp as the best risk-adjusted values today. Wells is currently trading at roughly a 30% discount to our fair value estimate of $67. This is well below the bank's historical trading multiples and implies that the Wells franchise is in serious decline. We don't see any reason why the current wave of legal charges and regulatory woes won't eventually be in the rear view mirror, and why Wells won't eventually recover to a high teens return on tangible equity and a more reasonable valuation.

KeyCorp is also nearly 30% undervalued compared to our current fair value estimate of $21. We believe that KeyCorp fundamentally transformed the franchise following the bank's First Niagara acquisition, overall we believe the integration has gone well, and we also believe the bank's credit culture has improved since the crisis. Despite some near-term growth headwinds, we believe the current returns on equity the bank is hitting today are here to stay, and eventually the market will give KeyCorp credit for its much improved operational performance.