The four largest commercial banks lead off Q3 earnings season this week, and their reports are certain to attract significant attention. In advance of those bank 8-K filings, it seems appropriate to review recent results by JPMorgan (JPM), Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC). Accordingly, this article explores the recent performance of these four stocks and sheds light on important valuation differences.
With the notable exception of JPM, each of the top four has spent considerable time in the penalty box during the past decade. Recent remarks by BAC and C management strongly suggest, however, their problems are well behind them, while WFC suggests it is turning the corner.
Bank Stock Performances
The dispersion in performance of these four bank stocks in 2019 is striking and worth further analysis. On a year-to-date basis through October 11th, C is up 34.7%, JPM is up 19.0%, BAC is up 17.3%, and WFC is up only 6.8%. Only C and JPM have managed to beat the S&P 500, which is up 18.5% for the comparable period.
At their current prices, JPM is trading at 1.95 times its tangible book value, BAC at 1.53 times, WFC at 1.46 times and C at only 1.04 times. On a price to trailing twelve month earnings basis, JPM is trading at 11.9 times, BAC at 10.3 times, WFC at 10.2 times and C at 9.8 times.
Based on the above two metrics, JPM has the richest valuation illustrating why market participants frequently refer to it as the best of breed. That moniker, however, does not guarantee it will outperform the other banks. In fact, investors reliant on only tangible book value and PE measures might want to do a pairs trade and short JPM while going long an equal dollar amount of one or more of the other large banks thereby betting there would be a reversion to the mean. Such a pair or arbitrage trade would be beneficial if JPM increases by a smaller percentage than the long bank stock position or if JPM decreases by a greater percentage than the long position.
Of course, investors in bank stocks are also interested in dividends. Based on closing prices as of October 11th, JPM yields 3.1%, BAC yields 2.49%, C yields 2.91% and WFC yields 4.15%. A yield conscious investor would likely suggest that WFC is the most undervalued of the four largest banks, since it has by far the highest yield. Such a view, however, ignores likely changes in dividend policy at these four banks.
Factors Determining Bank Profitability
Bank analysts in recent quarters have tended to focus on revenue growth and net interest margin, NIM, to differentiate bank performance. The decline in the general level of interest rates has caused revenue growth to be under downward pressure, while banks have struggled to maintain net interest margin as higher yielding securities have matured.
WFC had the highest NIM during Q2 at 2.82%, followed by C at 2.67%, JPM at 2.49% and BAC at 2.44%. Clearly, differences in revenue growth and NIM do not explain the differences in valuation among the four largest banks. Revenue growth and NIM are only two of the many factors that determine bank profitability, and both fail to identify structural shifts within banks that plant the seeds of profitability and bank stock performance.
Analysts have focused on the movement in the yield of the 10-year US Treasury as an indicator of bank performance, such that an increase in the yield on the 10 year is positive for bank income, while a decrease in yield is negative. Prognostications of bank earnings based on the rise and fall of the yield on the 10-year is highly questionable especially since banks generally do not buy such longer dated securities. Despite that fact, in recent weeks, the correlation between bank stock prices and the yield on the 10-year has been just about perfect.
Factors to Consider
Microeconomic theory states that, in the long run, it is the lowest cost producer that will prosper under conditions of free competition. In recent years, numerous new players have entered the banking arena, and funds from nonbank entities have become generally available. This heightened competition has cast a shadow over many areas of finance that were once dominated by big banks. At the same time, the banking industry has come under increased scrutiny and regulation as a result of past missteps.
In this new banking environment, banks that can produce products and services at the lowest possible cost will prosper. In 1978, I introduced a system of bank management I named asset/liability management in a five part series of articles I wrote for Banking: Journal of the American Bankers Association, ABA. I turned those articles into a book titled Asset/Liability Management, which was published by the ABA in 1981. That book became a best selling banking book in the USA, Japan and elsewhere when it was translated into other languages. While my articles and book focused on presenting a methodological approach I developed to define, measure and manage interest rate risk, it also identified factors that contributed to bank profitability.
This article extends my earlier work to shed light on the relative profitability of the four largest commercial banks in the USA: JPMorgan, Bank of America, Citigroup, and Wells Fargo. Hopefully, this article will help readers identify which of the four largest banks in the nation is truly the “best of breed.”
Break-Even Yield – BEY
Perhaps the most significant factor I introduced was what I called the break-even yield, BEY. It is based on the microeconomic principle of being the lowest cost producer. A bank’s break-even yield is the yield needed on its interest earning assets to have no net income. It is calculated by adding interest expense to noninterest expense, and subtracting noninterest income, then dividing that sum by interest earning assets, (IE+NIE-NII)/IEA. Trends in BEY are very important as are sudden aberrations.
The BEYs for the top four banks for the years 2016, 2017 and 2018 along with the BEYs for Q2 ended June 30, 2019, were examined. Disturbingly, the BEYs for the four largest banks increased in each of the past 3 years as well as into Q2 of 2019. Among the four, C had the highest BEY in 2018 (2.28%) and Q2 (3.01%), while JPM had the lowest in 2018 (1.43%) and Q2 (1.75%). The BEYs for BAC were very close to those of JPM in 2018 (1.49%) and Q3 (1.84%) and showed BAC had almost totally closed the gaps that had existed between itself and JPM in the last 18 months. The BEYs for the top four banks also showed that JPM and BAC have a competitive advantage in lending, since they can afford to lend at lower rates than WFC and C.
An examination of the trends in BEYs among the top four banks suggests that JPM does not deserve to enjoy a significant premium in its capitalization over BAC, since their BEYs are virtually identical. On the other hand, both JPM and BAC deserve to trade at a premium to WFC and especially C, since both have significantly higher BEYs.
Impact of Negative Interest Rates
Negative interest rates have become commonplace in many countries and that has caused investors to raise serious questions about commercial banks in such an environment. To most observers, bank lending or investing in a negative interest rate setting is a recipe for disaster. They cannot fathom how a bank could survive if it had to deploy funds in a negative interest rate situation.
The fact is that JPM, BAC and C could very well survive and prosper in such an environment because of their international exposure. At present, positive interest rates in the USA are a lure attracting large depositors from foreign countries now experiencing negative interest rates. The lure is enhanced by a strong dollar, which should only strengthen as foreigners convert their currencies into investable dollars.
As long as the interest rate paid by JPM and other large banks, plus the rate of appreciation of the dollar vis a vis the foreign currency exchanged leaves the depositor with more than they had before the transaction, they will continue to convert funds and invest dollars.
For illustration purposes, assume a German company has $10 million in Eurodollars to invest for one year and is offered -2% by a German bank and -4% by JPM for a US dollar deposit. Furthermore, assume the German company expects the dollar to appreciate by 5% against the Eurodollar during the next year and the current exchange rate is $1.11 USD for $1.00 Eurodollar.
If the company invests its Euros with the German bank at -2% then in one year it will be given back $9.8 million Euros. If instead of investing its money in the German bank, it converts the $10 million Euros into $11.1 million USD and invests those dollars at -4% with JPM, then at the end of the year it will receive $10.656 million USD, which would convert to $10.1 Euros if the dollar appreciated by 5% as expected. The depositor would be happy making such a transaction with JPM, because, at the end of the year, they would be better off by 300,000 Eurodollars ($10.1 million Euros versus $9.8 million Euros).
JPM, in turn, could afford to be generous and lend this particular deposit at -2% and earn a spread of 2% on the transaction. The borrower would pay the bank back $10.878 million USD on a $11.1 million USD loan and the bank would earn the difference between what it charged the depositor ($444,000 million USD) and what it paid the borrower ($222,000 USD).
It should be noted that in this hypothetical transaction JPM would also make money on the two foreign exchange transactions. I am sure JPM would be happy to earn a 2% spread or $222,000 on such a matched book of riskless business considering its BEY in Q2 was 1.75%.
The four largest banks have managed to recover from the worst financial conditions since the depression, are profitable and are as well capitalized as ever. They, however, have failed to capture the imagination of investors because of increased regulation, diminished trading opportunities, and increased competition from nonbanks.
JPM stock is overvalued relative to the other four largest commercial banks. A pairs trade whereby an investor shorts JPM while going long BAC, C and or WFC seems to have merit.
The strong international reputations of JPM, BAC and C are a major advantage in an era of increased capital mobility. Furthermore, these banks are the most likely to benefit from negative interest rates if they ever occur.
Disclosure: I am/we are long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.