Select Opportunities Remain as Banks Rebound

Editor's note: This article first appeared in the Q3 2021 issue of Morningstar magazine. Click here to subscribe.

During the pandemic, Morningstar equity analysts made their biggest call on banks in over 10 years—and it played out well. In a recent Financial Services Observer, Morningstar senior equity analyst Eric Compton explained why they see the sector as fairly valued today and already pricing in a series of future rate hikes. He also noted that selective investors can still find individual opportunities.

I spoke with Compton on the state of the sector, current opportunities, and how Morningstar differentiates its analysis. Our discussion reflects performance and valuations as of June 30.

Laura Lallos: Can you give a recap of how your postpandemic call on banks played out?

Compton: The pandemic was obviously a unique situation, with a lot of uncertainty. Any time there is potential economic damage, there will be questions around whether the financial system is strong enough to handle it. When unemployment goes from some of the best it's been in decades to numbers that make the recession of 2008 look not that bad, it's pretty jarring. Back then, the primary concern was about credit and capital for the banks. Would they survive or blow up again?

Since then, a lot of that uncertainty has abated. The economy has generally fared well enough to prevent major credit losses. In fact, we have seen almost no normalization of credit costs. But that was not a given. There were a lot of forgiveness or deferral systems set up in response to the pandemic that had never been done in that way on that scale before. Those balances were high enough that if they started to go bad, it could have been a serious issue.

Credit costs have come in below everyone’s expectations. There’s certainly been a lot of economic pain for a lot of people. But from the banks’ perspective, the economy has been good enough to keep credit costs quite low, and they have done quite well from a credit and capital perspective. If anything, they have excess capital at this point. Now, with increasing vaccination rates, the economy is reopening and GDP growth is back. Fee income related to spending and other activity-related fees that had been depressed are coming back now.

Coincidentally, during the pandemic, a lot of trading and capital markets and investment-banking-related fees and revenue did very well. Larger banks were almost countercyclical, and those lines of business are still doing quite well. A lot of signs now are positive for the banks, and the banks have done better than anyone could have hoped. We thought the banks would be able to handle the pandemic-driven downturn, and they did. It was a good call.

Shifting to more recent results, we were more bullish on credit than consensus, and Q1 earnings came in better than even we expected. There has been essentially no pickup in credit losses. For example, everyone’s paying down their credit cards. Almost no one is defaulting. Everyone’s a lot more positive after Q1, and we’re now more in line with consensus.

Lallos: I just interviewed Barney Frank, so I'm curious: How much of this positive outcome owes to the Dodd-Frank Act?

Compton: We have definitely seen a strengthening of the financial system due to the post-financial-crisis regulation, and Dodd-Frank was the major player in that. One of the biggest changes is that capital levels have gotten much higher. The magnitude of things that need to go bad is much higher now, and that increases the stability of the system.

During the last crisis, as long as you didn’t own mortgage-backed securities, you probably missed a lot of the pain. But the pandemic was so broad that it shut down almost the whole economy. It’s hard to diversify away from that. But even with that heightened risk, when I was looking through credit metrics I could not find a corollary to, say, Citigroup C in 2007, where potentially toxic exposures were very large compared to capital. This time around, when you look at capital levels, the scenarios you have to run to make things really fall apart are much more severe.

Lallos: Why isn't the mortgage lending boom cause for concern this time around?

Compton: Any time you hear about the housing market heating up, everyone gets a little worried because of the history there. But with the regulations, this time's a little bit different. Banks aren't doing adjustable-rate mortgages that are all going to reset at untenable rates at the same time a couple years in the future. The products in general are less risky. The overall size of the subprime market is not increasing the way it did during the lead-up to the financial crisis. If anything, credit scores and such are even improving. So, you don't see a lot of the danger signs that you saw in the past.

The one sign that is a little worrisome is housing price appreciation. It looks higher than normal, and this rate of increase doesn’t seem sustainable. I think there will be some buyer’s remorse, but it’s not going to be on the scale that we saw before.

Lallos: You wrote that in 2020, valuations were about credit and that today, it's more about net interest income.

Compton: The big question in 2020 was, is credit and capital going to be fine? We've answered that question and valuations have recovered to some degree. Now it's a question of how much banks will thrive after the pandemic.

Obviously, economic activity is going to play a role in growth in fee income and loans and such. But the biggest driver is going to be interest rates, because most banks have 50% or more of their income coming from net interest income, which is directly tied to interest rates. If you get a better interest-rate environment, half or more of your revenue is going to go up, without any additional costs. It’s almost a 100% margin type of improvement in revenue.

Rates are really the biggest driver going forward, and that’s the biggest question that investors need to think about when they’re thinking about investing in banks. Conceptually, yes, a lot of things are looking good for banks. But what are you paying for—are you OK with the assumptions that you’re making? I’ll be the first to admit I cannot predict with great precision where exactly rates will go and when. But what I can tell you is on average what you are likely paying for, and I think today people are paying for a fairly positive interest-rate thesis.

Lallos: You believe that prices today are accounting for about 200 basis points of rate hikes. But the way that Morningstar values stocks, the timing of the rate hikes doesn't matter so much, because you're looking at such a long time horizon.

Compton: Yes, as long as you get the overall picture right, it doesn't matter too much if you get it right today or tomorrow. The full life of the company is where most of the cash flows take place. If you're off by a year or two as far as the timing of that step up in cash flows, in the grand scheme of things, that makes a 1% or 2% difference on average per year for most of the banks under my coverage.

You still are subject to the timing of the market. You might be right as far as the overall picture, but you may have to wait a couple years before the market starts to price it in. Theoretically, that shouldn’t matter too much if everyone’s investing for the long term. But I get it. You’d rather see things go up sooner rather than later.

Lallos: You noted in your report that bank valuations are not as tightly linked to yield curve steepness as people think.

Compton: You hear a lot that the yield curve steepening is good for banks. But you have to get past such one-liners, because that's not always the case. Yield curve steepness is a function of both the short end and the long end of the curve, so you can get steeper by dropping the short end or by raising the long end. And oftentimes, what's happening on the short end is much more relevant, not only because it tends to have a larger absolute impact on the banks, but because it's a sign of what the Fed is up to: If the Fed's cutting rates, that is usually a sign the Fed is worried about an economic slowdown or something of that nature.

If the yield curve is steepening as the result of economic strength, that is a net positive for the banks. But then how much is that actually going to affect bank profitability, and how much of that is already priced in?

Lallos: Banks will be allowed to do share buybacks again later this year. Are there some stocks that will benefit more than others?

Compton: Everyone will benefit to a degree. There's a lot of excess capital in the system. Banks haven't been able to buy back shares during the pandemic, so there's pent-up capacity. After the Fed stress tests, they should go back to normal. They will be free to spend excess capital as they please, as long as they satisfy the capital requirements.

One name that has stuck out for us has been Wells Fargo WFC. We think they have a lot of buyback capacity. They aren’t the most profitable. Their returns still aren’t the best. They’re still working through a lot of issues on regulatory expenses. And they are fairly rate-sensitive, so that’s hurt their profits a little bit more than peers. But they also have a ton of excess capital. We don’t think it’s unrealistic that Wells could repurchase 10% or more of its shares over the next year.

Capital One COF is another name that has a lot of excess capital, enough where we wouldn’t be surprised to see the bank be able to buy back 10% or more of shares over the next 12 months. A lot of the other banks should still be able to repurchase shares, just not quite as much, probably closer to a 5%–10% range over the next year based on excess capital and how much we expect them to earn. In general, it’s a sectorwide story: Buybacks are coming back, and shareholders who stick around will own a larger percentage of the company.

Lallos: Wells Fargo seems to be a turnaround story. What's going right?

Compton: Wells Fargo has been in regulatory purgatory, especially as it relates to the asset cap, which is probably the biggest regulatory item on most investors' minds. With the asset cap, Wells Fargo is not allowed to grow the balance sheet. Putting a cap on the balance sheet puts a cap on loan growth, and it's also a reputational stain that stays with the company.

A big part of the turnaround is getting the asset cap removed. They’ve been working on that for over three years now, and regulators reportedly signaled in February that they had internally approved the plans that Wells put forward. That was the first time that there had been any sign of progress with the regulators. That’s part of the turnaround. We now expect the asset cap to be removed in Q4 of this year or Q1 of 2022, which would finally put an end to what has been a multiyear saga. It seems like they’re making some progress, and I think that’s one reason why shares have traded up and they aren’t quite at the discount they used to be.

Another part of the turnaround is working through a bloated expense base. One reason expenses are bloated is because of spending on all these regulatory initiatives. So, some of that spending should come down. Also, as they’ve been working on these regulatory items, they haven’t made much progress on increasing the overall efficiency of the bank. I think they’ll start making some progress going forward. Wells came out with their first expense guidance under new management back in Q4 of 2020, which was another sign that this expense turnaround is finally going to start to happen. The final part of the turnaround is strengthening the franchise and restoring its reputation. I think they’ll be able to make some progress on that in 2022.

You don’t want to be in a stock and have it sit around for three years, which has been the case with Wells to some extent. Now we’re getting more tangible signs of the timing of this progress, and that’s been a reason shares have traded up.

They still trade at a slight discount. Right now, I have them at 10% undervalued—while I have the overall sector as roughly 10% overvalued. Finding any discount on my coverage list right now is about the best you can hope for, whereas a year ago, some names were under 50% of my fair value. Wells is one of the few that I think still has some potential upside.

Lallos: Any regionals still looking like something of a value?

Compton: The only regional to me that looks 5% to 10% undervalued or more is Huntington Bancshares HBAN. It isn't as obvious a story as Wells. It's more difficult to tell exactly why the market doesn't believe in them as much as I think it should.

Part of it is that we are giving them some extra value for their merger with TCF Financial. I think that’s a catalyst. They’re going to gain scale and maybe the market isn’t giving them full credit for that. Also, Huntington has had decent loan growth in the past, and that’s slowed down a bit for the whole sector. Maybe when that starts to pick up, it will help. But otherwise, I’d say that they’re a pretty normal regional bank with a nice mix of consumer and commercial business. They’re spread out, particularly throughout the Midwest and they’re decently run.

Lallos: Valuations aside, who are the standouts on your coverage list in terms of moat or as capital allocators, names investors should keep an eye on?

Compton: The number-one franchise in pretty much anyone's mind these days when it comes to U.S. banks is JPMorgan JPM. They're not only the largest, but they have a history of excellent management. Jamie Dimon's basically a celebrity among managers of large corporations. They have a complete franchise. Whether it's asset management, wealth management, investment banking, trading, retail banking, cards, they have it all. They have a very strong U.S. presence and they're building out their international presence.

Being large can be an impediment to being innovative or changing infrastructure or technology. But they try to make up for that with the largest tech budget in the industry. They’re investing billions of dollars in this kind of stuff. As banking becomes more digital, more about fintech, that’s going to matter more. If you had to pick a bank among the banks, JPMorgan’s one I would keep an eye on. They tend to not get cheap, because they’re so highly respected. During the pandemic was one of the few times they traded materially below my fair value.

Among the midsize regionals, I would highlight M&T Bank MTB. They have a strong commercial real estate operation in the Northeast, particularly in New York City. They have a history of good management and credit costs have been exceptional for them over the decades.

They have a merger catalyst as well: They are acquiring People’s United Financial PBCT at a decent price. It’s going to offer a nice expansion of the geography they service as well as the types of customers they service. There will be some expense synergies, as well. They still seem about fairly valued to me. So, that’s a quality franchise that isn’t too expensive yet.

The final one I would highlight is the smallest bank I cover, Cullen/Frost Bankers CFR. This is a classic old-school bankers’ bank; it’s very relationally driven. They’re a Texas-only bank and they take a lot of pride in that, in knowing their local markets. They have a long history of good management and have survived many downturns when many banks, particularly in Texas, have failed—whether during the financial crisis, or the energy downturn prior to that, or the S&L crisis.

They, coincidentally, are also in the middle of an expansion. They aren’t doing it by acquiring a competitor, but rather purely through organic expansion. They’ve opened a number of new financial centers, and they just announced plans to do a whole new wave of openings in new geographies in Texas. That’s another nice lever for growth. They, unfortunately, do look fairly pricey to me at this point.

These three companies all have Exemplary capital allocation ratings—which is rare among my coverage.

Lallos: Any final words of advice for investors?

Compton: Valuations are not anywhere as cheap as they used to be, so the easier money has already been had. And banks are cyclical. If you buy a company like a bank more at the peak of a cycle or the peak of cyclical valuations, you're probably not going to see excess returns. I can't tell you how good the economic boom's going to be, how long it's going to last, or the timing of rate changes. There are a lot of things that could turn out better than anyone expects. Just keep in mind that valuations are reaching up toward the higher end of what we've seen historically, and these are cyclical companies.

They could keep going up in the short term, especially with people worried about inflation. A lot of industries aren’t a natural hedge to inflation, and there’s no telling how long this sentiment of excitement about banks as an inflation hedge will last. But at these prices, you are counting on a fairly positive outlook.

Laura Lallos is managing editor of Morningstar magazine.

[1] Compton, E. 2021. "Banking Outlook 2021: Banks Have Survived the Pandemic, Now How Much Should You Pay for Them?" Morningstar Financial Services Observer, April.