Bank stocks stink, so time to buy banks?

Traders work the floor of the New York Stock Exchange.
Adam Jeffery | CNBC
Traders work the floor of the New York Stock Exchange.

A funny thing has been happening to financials: while earnings have been stellar, their stocks have stunk.

Broadly speaking, financial industry companies on the S&P 500 are expected to post first-quarter earnings gains of 15.8 percent, easily outdistancing other sector competitors on the broad market index. If profits are the primary drivers of prices, you'd then expect their stocks to be blooming.

That has not been the case.

Financials, in fact, are the second-worst performing group of the 10 S&P sectors, registering a loss of 2.3 percent heading into Tuesday's trading. Only utilities, which have tumbled 5.6 percent, have fallen further.

The results are even worse drilling down into bank stocks specifically.

Banks as a whole are off 3.4 percent, even though Keefe, Bruyette & Woods reports that 54 percent have beaten consensus profit estimates. Consumer finance stocks have dropped 11.3 percent. Thrifts and mortgage finance institutions have slid 4.5 percent, while real estate-related institutions have been one of the few outperforming groups.

Banking winners and losers

Sector
YTD Performance (%)
Real Estate Management 12
REITs 1.18
Real Estate -1.4
Insurance -2.14
Diversified financials -2.73
Commercial banks -3.42
Banks -3.43
Thrifts and mortgage finance -4.48
Consumer finance -11.28
Source: FactSet

"The obvious question is why have these stocks done so poorly? The simple answer is the deterioration in their return on equity," Dick Bove, vice president of equity research at Rafferty Capital Markets, wrote in a research note for clients. "I do not expect to see the return on average equity rise meaningfully because the government keeps mandating increases in equity, and restrictions on the use of capital."

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Return on equity, or the profit institutions generate against the cash they get from investors, had seen double-digit increases from 2000-07 across all banking industry sectors but has tumbled since then, particularly for universal banks JPMorgan Chase, Bank of America, Wells Fargo and Citigroup. (ROE for the group in the first quarter did rise 10.2 percent compared to a year earlier, but the comparables were fairly easy.)

Bove rued the returns his coverage universe has seen: The 19 stocks he rates a "buy" gained just 3.3 percent from the first quarter of 2015 compared to the same period in 2014, a time during which the S&P 500 rose about 13 percent. Bove's "hold" stocks fell 1.5 percent during the same one-year span.

However, he has not completely lost heart on the group. An improving economy and rising interest rates give hope that the banks can outperform if not in 2015 then in the following year.

"That leaves valuation as a reason to buy the stocks—i.e., the valuation parameters in the market are rising but they are not rising for bank stocks," Bove wrote. "Thus, a gap is opening up which could result in better performance for banks."

Analysts no doubt will be giving the sector a closer look.

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Small- and mid-caps in the industry actually posted the strongest profits compared to expectations, with 58 percent topping Wall Street estimates, according to KBW, which has modestly upgraded its bank earnings growth projections to 8 percent in 2015, while keeping 2016 estimates at 11 percent.

Lindsey Bell, senior analyst at S&P Capital IQ's global markets intelligence division, believes this year's share price underperformance is presenting opportunities. She specifically mentioned Capital One as an example of a company that will benefit from consumer strength in a rebounding economy.

"There certainly seems to be a disconnect between the earnings trajectory of the group and stock performance," Bell said in a note. "As such, opportunities could be found for stock pickers in companies with compelling valuations and sound operating strategies (including the ability to execute those strategies) within financials."