It wasn't all that long ago that bank stocks rocked. The performance of the Dow Jones Global Sector Titans Bank Index regularly topped the U.S. broad market in dollar terms through the end of 2006. During that year, bank shares soared nearly 20%, besting domestic stocks by nearly 14%. Three-year annualized gains exceeded 12.5% while domestic shares scored a mere 2.68%. And five-year bank returns were nearly double the average domestic shares, exceeding 10.2%. Even through June of 2007, despite growing industry concerns, the index was still registering double-digit gains over the same three periods.
However, by the end of January, the collapse of banking shares-especially in the U.S. and Britain, which make up half of the market-cap weighted benchmark-had driven down the index's one-year returns by more than 21%.
The factors contributing to this devaluation describe a vicious cycle-a metastasizing subprime mess of unknown proportions and soaring mortgage defaults; the corresponding massive write-downs of mortgage-related products (including those that were off balance sheet); the opacity of asset valuations; shrinking liquidity; volatile credit spreads in all qualities of debt; more restrictive lending standards; and fear that all of this is sending the U.S. economy into recession.
However, a key indicator of when to start buying into a beaten industry is when investor capitulation is near complete. Some may argue we saw such a scenario at the end of last year. At that time, Citigroup's domestic equity strategist Tobias Levkovich raised his "industry recommendation [on banks] to overweight," he says, "reflecting [their] compelling valuation, depressed earnings revision data and awful investor sentiment."
Around the same time, Legg Mason's venerable value manager Bill Miller wrote that, "The greatest gains over the next five years will be made in [these] securities people are panicked about today." Banks are front and center in this group.
Bank shares have continued to slump, regardless. But in the long term, these prognostications will be proved right. The question is how to gain this exposure without risking coronaries for you or your clients. We first recommend differentiating among the various types of domestic banks. They are far from all the same. Then let's move abroad, and discuss both big developed-market bank shares and those of fast-growing emerging markets. We conclude by looking at different kinds of shares one can buy.
Money Centers Versus Regionals
The country's largest banks are money centers whose activities go well beyond deposits and lending. They also engage in corporate and investment banking, asset management, private equity and brokerage services. These firms have driven subprime lending and the securitization boom. They are front and center in the eye of the banking crisis, and many have seen their shares collapse by 40% to 50% since the second quarter of last year.
Some were hurt worse than others. Jeff Harte, a managing director at Sandler O'Neill, was surprised by the magnitude of credit deterioration at Citigroup, with non-performing loans having increased by 79% in the fourth quarter from the fourth quarter of 2006. Write-downs for the year neared $29 billion. Citi is paying a high cost to refinance its balance sheet, while it has slashed its common dividend by 40%.
Accordingly, Harte lowered his 2008 earnings per share estimates by more than one-third. "We continue to like Citi's long-term business prospects," he says, "but we believe there is still too much uncertainty surrounding the company's financial outlook to recommend the stock at this time." In late February, shares were trading close to their low for the year, worth less than half of what they were just last summer.
Bank of America also took a nasty hit. But its shares have shown a greater propensity to rebound than Citigroup's. Jeff Arricale, the portfolio manager of T. Rowe Price's $364 million Financial Services Fund, with five-year annualized returns of more than 11% through February 7, thinks the bank remains safely capitalized, which should protect its dividend. He also believes BoA's acquisition of U.S. Trust, Countrywide Savings and LaSalle will likely boost earnings growth by 10% to 13%.