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​It could be time to bet on the big banks

The financials -- the major banks, in particular -- have been out of favor for months now, with the S&P 500 Financial sector underperforming the S&P 500 index in recent months.

However, "We believe the market is overly fearful about the prospects for large U.S. banks following fourth-quarter results," said Jim Sinegal, banking analyst at Morningstar, adding that investor "pessimism regarding the group is overdone." For starters, it's one economic sector that has escaped heavy damage from the plunge in oil prices.

Energy exposure is limited, especially relative to exceptionally high capital levels among the banks, notes Sinegal. In the 1980s, "nonperforming loans at oil banks peaked above 10 percent of total loans -- none of the country's latest banks have energy exposure anywhere near this level," he said. So, he's optimistic about the outlook for the banks' major markets, such as the housing industry.

And the stability of the slow-growth U.S. economy, increasing vitality of consumers and the Federal Reserve's inclination to pursue a path of raising interest rates, if incrementally, are emerging positives for the big banks, some analysts argue.

The improvement in housing are also likely to be big boon for the banks. "We remain bullish on the prospects for housing in the medium term as the millennials age, especially if the employment market remains strong and mortgage credit becomes easier to obtain," said Sinegal.

Erik Oja, S&P Capital IQ's bank equity analyst, said the Fed's rate hike attempts to "recalibrate, not restrain." In other words, the Fed isn't trying to slow down a fast-growing economy or dampen runaway inflation. Oja noted that the Standard & Poor's Economics unit projects the U.S. economy will grow 2.7 percent in 2016, below historical growth rates, while inflation remains well under control due to energy price declines.

The nation's largest banks, said Oja, will immediately benefit from rising short-term interest rates, including JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC), in part because they've had years to reorient their balance sheets toward the short-end of the curve yield. "The largest banks have significant amounts of their assets in federal fund securities and other extremely low-yielding investments," noted Oja, so they'll surely benefit from a hike in interest rates.

In fact, all banks benefit from rising long-term interest rates, particularly if they climb faster than short-term rates and lead to wider net interest spreads, Oja pointed out. S&P Capital IQ recommends the four major banks -- JPMorgan, Bank of America, Citigroup and Wells Fargo -- as "buys."

Oja has a 12-month price target of $65 a share for JPMorgan, currently trading at $58, off from its 52-week high of $70.61. Among the positives for the stock, he said, include a lower capital surcharge of 3.5 percent instead of 5 percent, JPM's willingness to estimate a $750 million addition to reserves if oil stays at $30 per barrel for a year and strong consumer lending growth and asset quality.

"Our risk assessment reflects our view of the company's well-reserved balance sheet, diversified lines of business and strong capital ratios," Oja said.

Morningstar's Sinegal has raised his "fair value" price estimate for JPM to $66 a share from $64, based in part on management's belief that it can reduce expenses in consumer banking by another $1 billion annually and another $1.5 billion in the corporate and investment bank, with part of the savings to be reinvested rather than passed on fully to the bottom line.

Worries in the capital markets, including volatility in trading, investment banking and asset management revenue, said Sinegal, won't alter his fair-value estimate.

On Citigroup, Sinegal said the bank remains a "best idea on valuation," trading at a "substantial discount to our $68 a share fair value estimate and its $60.61 tangible book value per share."

At the same time, Bank of America once again "looks attractive as well," he said, "and we see it as well positioned to benefit from a rebounding U.S. consumer as well as eventual rising rates." Shares of BofA are trading at $14, down from Sinegal's fair value estimate of $17 a share.

And "wide-moat Wells Fargo is likely to be the least volatile of the large banks, with its minimal exposure to capital markets businesses," he said.

S&P's Oja said the many improvements that Citigroup has made to capital levels, credit quality and earnings stability over the past few years are offsetting the bank's exposure to risky assets on its balance sheet and to uncertain credit conditions in domestic and international markets.

The analyst has reduced his 12-month price target to $48 a share for Citigroup, reflecting the bank's exposure to emerging markets. Nonetheless, Oja is maintaining his "buy" recommendation on the stock.

Morningstar's Sinegal said despite headwinds buffeting Citigroup, including problems in emerging markets, the stock is "quite cheap at current levels, even if earnings deteriorate significantly from here." He also thinks the bank is now well positioned to endure any downturn, in contrast to 2008.

With a 12 percent common equity Tier 1 capital ratio ($146.9 billion in capital), a 7.1 percent supplementary leverage ratio, $12.6 billion in loan-loss reserves, and a few esoteric assets, "Citigroup will weather the storm in emerging markets, in our opinion," said Sinegal.

BofA is becoming more attractive, he said, trading at a discount to both his fair value estimate of $17 a share and $15.62 tangible book value per share, even as the bank's performance has improved. Over the medium-term, the analyst thinks "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."

S&P's Oja said his "buy" rating on BofA reflects the numerous improvements it has made to its capital ratios, revenue growth and profitability.

Some positive developments at Wells Fargo have attracted Well Street's attention. The bank, whose stock is currently trading at $50, is well positioned to increase net interest income notably, said Todd Rosenbluth, equity analyst at S&P Capital IQ. He believes the stock is undervalued on a price-to-earnings-ratio basis, aided by loan growth that's faster than its peers. However, the persistent net interest margin compression due to its larger base of deposits has held back growth of net interest income.

But if and when long-term interest rates rise along with an improving U.S. economy, Rosenbluth sees Wells Fargo as well positioned to raise net interest income significantly. The bank, he added, has "solid business fundamentals and a strong customer base," that's only partly offset by regulatory and legal risks.

For investors who would rather use ETFs to invest in the major banks, the SPDR S&P Bank ETF (KBE) is one that provides exposure to the banking sector. This narrowly focused exchange-traded fund tracks a benchmark index that excludes non-bank financial institutions such as REITs, insurance companies and pure-play investment banks.

Robert Holdsborough, analyst at Morningstar, cautions that the fund's focus means it tends to be slightly more volatile than broader financials-sector funds, like Financial Sector SPDR (XLF), which allocates 37 percent of its assets to banks. He notes that although most traditional deposit banks hedge a portion of their interest-rate risk, they are especially sensitive to changes in the shape of the yield curve.

So Holdsborough advises that KBE is an appropriate tactical satellite holding for investors who have a "high risk tolerance and want to bet on a steepening yield curve and further improvements in the banking sector."

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