Sectornomics: Financials

Why it's time to invest in bank stocks

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It was just over six years ago that Lehman Brothers Holdings filed for Chapter 11 bankruptcy and put America's financial institutions in turmoil. In the six months after the bank's stunning collapse, the S&P 500 financial sub-index dropped by a whopping 67 percent, and most investors wanted nothing to do with this once-mighty sector.

Time tends to heal all wounds, but when it comes to financials—and especially the banks—many people are still feeling burned. The sector is up just 26 percent since Lehman's bankruptcy, compared to 68 percent for the S&P 500.

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Craig Warga | Bloomberg | Getty Images

A number of big banks are also trading at lower-than-market price-to-earnings ratios. Wells Fargo, for instance, is trading at 13 times earnings, while JPMorgan is trading at about 15 times. The S&P 500 is trading at about 17 times earnings.

While most bank stocks have seen their share prices rise off their recession lows—Bank of America is up 216 percent over the last two years—they still have a lot more room to grow, said Andrew Sleeman, a portfolio manager with Franklin Mutual Financial Services Fund.

"The economy is starting to pick up, we're starting to see some loan growth, and an interest-rate rise could lift the whole sector," he said. "If rates do climb, then financials could be the sector to be exposed to."

Rough ride from regulators

The cautious approach that investors have had toward banks over the last few years is due, in part, to new regulation that was enacted after the crisis.

To ensure that no bank would ever fail again, American regulators forced the country's banks to have a tier 1 capital ratio—total equity to assets—of at least 4 percent.

Regulators also forced companies to slash their dividends and curb their share buybacks. That in itself was a blow to investors, who used to rely on financial-sector payouts for income. While most people would say that there was a need for some regulation, many think it's gone too far.

"It doesn't make the system any safer or better," said Michael Liss, vice president and portfolio manager with American Century Investments. "In a lot of cases, it's disadvantaged U.S. financial institutions."

All these regulations could hamper future growth, as well.

Before the recession, many of the big banks were trading at around 20 times earnings. Because companies are now restricted on how they can spend their growing capital, it's unlikely they'll get that high again, said Liss.

"Price-to-earning and price-to-book ratios will be lower than in the last decade," said Liss. "They're inexpensive as a group relative to the market but should be trading at some kind of discount because of the many constraints they have on the business."

Better times ahead

Just because bank multiples may not get back to their heady pre-recession levels doesn't mean they're not improving.

The sector's valuations have been fairly volatile since the recession, but they're now stabilizing, said Erik Oja, a banking industry analyst with S&P Capital IQ. That's good news, as it's making it easier to value the banks and figure out where they're headed.

The improved environment allowed Citizens Financial Group to engineer a , the first bank IPO issued in 10 years. Citizens is the country's 13th biggest retail bank holding company, with about $130 billion in assets. Headquartered in Providence, Rhode Island, the bank was bought by Royal Bank of Scotland in 1988 and expanded through acquisition.

Although the IPO fell short of Citizens' target price—it priced at $21.50 per share, below the expected $23 to $25 per share—it is the second-biggest market debut for the U.S. this year, behind Alibaba, and a major step to help end the U.S. bank IPO drought.

Oja is optimistic. Now could be a good time for the average investor to buy in, he said, because loan growth numbers—an important metric for the banks—are improving.

In the second quarter, total loans increased for the fifth straight quarter, this time by $178.54 billion. Out of the 15 biggest banks, only Bank of America failed to increase lending.

Read MoreBank of America shares to rise 50 percent in three years: Barron's

Dividends are finally starting to rise, too. The average financial sector yield fell from 4.44 percent in December 2008 to 1.22 percent in December 2009, according to S&P Capital IQ.

The average yield is now about 1.8 percent.

The financial sector also accounts for 14.77 percent of the S&P 500's total yield. While that's still down from about 20 percent before the recession, it's up from 9 percent in 2009.

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Some companies have already increased their dividends substantially—Wells Fargo's dividend is up 565 percent since 2010—while others, such as Citigroup, which pays a $0.04 dividend per share, haven't yet received the go-ahead from regulators to up their payout.

However, investors should expect dividends to rise further as regulators start relaxing some of the rules, said Sleeman.

"It's a huge opportunity for total return to improve," he said. "Whether it's through buybacks, dividends or a combination of both, there's certainly an opportunity to increase returns to shareholders."

At least one of the benefits of tighter regulation is that bank balance sheets are in the best shape they've ever been in, and that should go a long way to improving people's confidence in the financial system, said Sleeman. If companies have money to get them out of a jam, the less likely they'll suffer Lehman's fate.

Their fortunes should also get better the more the U.S. economy improves. When interest rates rise, possibly next year, banks will finally make more on their loans. That rate bump is not priced into the stocks, Sleeman explained.

Read MoreCitizensFinancial's IPO priced at $21.50

Look for growth

America’s largest banks

Symbol Company name Asset size<br> (in mils)
FNMAFederal National Mortgage Association $3,226,505
JPMJPMorgan Chase & Co. $2,520,336
BACBank of America Corporation $2,170,557
FMCCFederal Home Loan Mortgage Corporation $1,916,618
CCitigroup Inc. $1,909,715
WFCWells Fargo & Company $1,598,874
USBU.S. Bancorp $389,065
PNCPNC Financial Services Group, Inc. $327,064
SBKCQSecurity Bank Corp. $258,900
BBTBB&T Corporation $188,012
STISunTrust Banks, Inc. $182,559
FITBFifth Third Bancorp $132,562
RFRegions Financial Corporation $118,719
KEYKeyCorp $91,798
MTBM&T Bank Corporation $90,835

Source: Source: FactSet

With about 7,000 banks in the U.S., investors can't just buy any one. Some of the big and midsize banks offer the best opportunities, said Oja, and while each institution will give investors something different, investors should always be keeping growth in mind.

One of the banks that Oja recommends is JPMorgan, which has grown its revenues by 77 percent between 2008 and 2013. Its return on capital is "strong"; it's been able to add a lot of money to its capital ratios over the last four years, and it's growing globally.

The smaller, SunTrust Banks is also on Oja's buy list. It's seeing good growth in the Southeast, it's improving its commercial loan growth numbers, and it should be one of the big beneficiaries of the continued U.S. recovery, he said, adding that it's trading at about 12 times earnings, but that multiple will certainly grow.

While Liss has a more neutral opinion on the banking sector overall, he does like high-quality banks, such as JPMorgan, Wells Fargo and PNC Financial Services Group. He's also interested in banks that are growing through acquisition, such as M&T Bank, which is in the midst of buying Hudson City Bancorp.

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Also look at companies with a management team that has been through the recession, as they should know what to do if another crisis hits, said Oja. Banks that didn't have any losses in 2008 —PNC and U.S. Bancorp, for instance—are also good bets.

Overall, the sector does seem to be looking up. Expect revenues from the mid-sized banks to grow by at least 10 percent annually, while dividends and share buybacks should help push the prices of the big banks higher, said Oja.

"It's a different world than it was in 2006, but our outlook on the banks is still positive," he said. "People should certainly look at this sector."