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Time to 'aggressively' buy big banks

Investors have been very good to the nation's biggest banks so far this July, with several of our Rafferty Capital Market Indexes that measure bank-stock performance up more than 5.5 percent, while the S&P 500 is up by just 3.1 percent. Is this merely a catch-up in a group that has underperformed the market or has something changed? My belief is that something has changed; in fact, many influences have changed and all of the changes have been positive.

Dick Bove
Source: Dick Bove
Dick Bove




Operating earnings strong

Let's start with earnings. The best technique for looking at these figures is to analyze a number called pretax, pre-provision earnings. This number shows bank earnings from operations. It does this by eliminating the impact of loan losses and reserve releases on results.

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In recent years, banks have been experiencing a significant decline in loan losses. They have also been reducing the amount of money set aside in reserves. This is a very positive development but, by including loan-loss results and reserve releases in bank-reported profits, the illusion is created that bank earnings from operations have been improving. In fact, until just recently, they have not been.

Therefore, what is very significant in most of the bank-profit figures being released in the past week is that earnings from operations are growing again. They are not just growing, they are jumping. The universal banks (Bank of America, Citigroup, JPMorgan Chase & Wells Fargo) have all reported and the index for these banks shows earnings from operations up nearly 23 percent when the average profit of the past four quarters is compared to the prior four-quarter period.

Asset quality meaningfully better

The quality of bank balance sheets has clearly been positively impacted by the reduction in problem loans. In fact, in many cases, banks are selling troubled loans at a profit compared to their marked-down values.

The fact that the regulators have forced banks to add a significant amount of equity to their balance sheets is well known. What is less well understood is that the banks have also been forced to increase their liquid assets. They hold an estimated $2.6 trillion dollars in deposits at the Federal Reserve and they have meaningfully increased their ownership of government guaranteed securities because they have been told they must do this.

The addition of capital, cash, and government-backed securities means that the book value of these companies is very real. Yet, at least two of the big banks sell at a discount to this value.

Outlook

The outlook for these companies on an operating earnings basis is quite bright for multiple reasons:

The economy is improving. Even if it only grows at 2.0 percent to 2.5 percent per year, this means that banks will make more loans. The increase in commercial and automobile lending is well underway. It now appears that credit cards and home-equity activity is also on the rise.

The Federal Reserve may not raise interest rates this year but it is going to at some point. This is the price banks sell their products at and it means that the margin on the new loans being originated is going to grow.

Expenses are falling in multiple areas.

  • New regulations are not as onerous in terms of causing higher operating costs as the ones put in place over the past five years.
  • Litigation will continue for many years but the amounts that banks will pay out are unlikely to come remotely close to what they have already paid.
  • The need to spend large sums for employees who deal with bad loans has shifted and these people are now losing their jobs

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M&A on the rise. The global economic upset is creating the need for more company consolidation and, therefore, more merger and acquisition fees.

Increase in trading activity. The surge in global money supply is providing the raw material for a sustained increase in trading activity.

I would argue that, most importantly, investment psychology is shifting toward this group. The attitude that banks are utilities that can never show earnings gains is disappearing. The view that bank asset values are overstated is gone or should be gone. The view that the government has multiple new ways to attack these companies is also disappearing even though the industry has been de facto nationalized.

Investors see the positives. They now want to own these shares rather than sell them. They see a protracted gain in earnings developing.

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These stocks are cheap. As returns on equity rise, this will become even more apparent. The constant increases in dividends and stock buybacks will further underline this fact.

Big bank stocks should be bought aggressively in my view.

Commentary by Richard X. Bove, an equity research analyst at Rafferty Capital Markets and the author of "Guardians of Prosperity: Why America Needs Big Banks" (2013).