By James A. Anderson Rate cuts and bank stocks go together like protein bars and athletes. A drop in rates feeds bank shares. That certainly has been the case the past couple of months.
Back in December, while some market pundits started thinking rates had peaked, savvy investors sensed a round of cuts coming. In anticipation, bank stocks took off during the month before Federal Reserve Chairman Alan Greenspan chopped away twice at lending rates in early 2001.
During the 13-week period that ended Feb. 16, a Standard & Poor's index of regional banks climbed 22.4%, and savings and loans rose 19.4%. Major regional banks sped off on a 17.8% tear. That's to say nothing of money-center banks, the sector's 800-pound gorillas, which charged up some 28.5% over the same stretch.
CREDIT ON SALE. There's a good reason why bank shares thrive when interest rates drop. Lower rates mean banks' raw material -- cash -- is cheaper to get. It lets pinstriped loan officers put credit on sale, which perks up demand for loans and helps banks draw in new revenue. And in turn, banks' earnings are pumped up, and financial institutions find it easier to boost their return on equity.
With the economy possibly stalling, rates are especially important to banks. As companies' profits drop, banks often end up with increased write-offs for bad loans and defaults, which chips away at earnings. But lower rates make it easier for corporate debtors to service their loans and help keep potential defaults to a minimum.
Analysts say the rate-driven rally could benefit bank stocks one more way: It may well trigger another round of industrywide consolidation. With their shares worth more, merger-hungry banks have extra spending power to shop for acquisitions.
Now that 2001 has sent bank stocks upward, portfolio manager Raymond Stewart of Rasara Strategies says the chances are good that a number of big industry players are ready to start prowling again for acquisitions. Indeed, the latest round of consolidation may have already started: On Feb. 12, Citigroup (C) snared EAB from the Dutch financial firm ABN Amro (ABN) for $1.6 billion. A day later, North Fork Bancorporation (NFB) nabbed Commercial Bank of New York (CBNY) for $175 million.
DARK SPOTS. As bright as the picture for bank stocks has been, there are some dark spots. For one, the sector's earnings growth is bound to be affected by a more sluggish economy. Fox Pitt Kelton analyst Jon Balkind says the sector can look forward to 7% to 8% earnings growth in 2001, a drop from the 11% average annual increases it enjoyed in the '90s.
A second caveat for investors: The current boom can't go on forever. According to Balkind, rate-driven rallies have, on average, lasted three months after the Fed's first cuts, and they've pushed bank shares up 27% following the first Fed intervention. At the end of last week, by Fox Pitt's calculations, the group had already moved 20%.
If you're late getting in on the run-up in bank shares, keep one thing in mind: Your best bet is undervalued shares that will take a little longer to catch up to the pack. One stock that fits that description is AmSouth Bancorp (ASO). A Birmingham (Ala.) outfit, AmSouth decided to brace itself early for upcoming credit problems by taking an aggressive $260 million in write-offs for its third quarter ended Sept. 30. A disappointed Wall Street cast off AmSouth's shares, and the company's stock finished down 17% in 2000.
"ADMIRABLE." That has left AmSouth shares trading at a steep discount to their peers. With its Feb. 23 close of $17.46, the stock fetched a price just 12 times the Street's consensus 2001 earnings estimate of $1.44. That's 36.7% below the 16.4 multiple bank stocks now fetch, according to Morningstar.
Portfolio manager Stewart says it was "admirable" for AmSouth to take its lumps early. "Besides that, the company has a good franchise in Southeastern states, including Tennessee, Florida, Georgia, and Louisiana, and could be an attractive pickup for a larger operation looking to expand in the Sun Belt," he notes.
Stewart thinks AmSouth should have a price of $20 a share in six to nine months. Zacks Investment Research reports Wall Street is more cautious on the stock, with only 1 of the 17 analysts that follow it rating it a strong buy or buy.
Chase -- now part of J.P. Morgan Chase (JPM) -- is another company that still looks modestly priced because it languished last year, retreating 12.3% in 2000. Based on Wall Street forecasts compiled by Zacks that the company will earn $3.73 a share in 2001, the stock now carries a price-earnings multiple of just under 13, based on its Feb. 23 closing price of $48.49.
SLIMMING DOWN. Now that its merger with J.P. Morgan is completed, the bank is ready to slim down. Management overseeing the integration has already targeted about $2 billion in cost savings, says ING Barings analyst Andy Collins. "I think they'll achieve that number with relative ease, and should the economy fall off, cost-cutting alone would go a long way to driving J.P. Morgan Chase's story," he adds.
Besides slashing away at outlays, J.P. Morgan Chase is on track to boost revenues some 13% this year, says Fox Pitt Belton analyst Denis LaPlante. He thinks the stock could hit $65 in the next 12 months. Zacks reports that 18 of the 19 analysts that follow the company rate it a strong buy or buy, and Wall Street looks for J.P. Morgan Chase earnings' to grow an average of 11.4% annually over the next five years.
If you're looking for a fund play in the banking sector, you've got a lot of choices. According to Morningstar, 79 financial funds are on the market. A close look at portfolios reveals that many money managers have added a good dose of brokerage and insurance stocks to their banks and S&L holdings.
CLEAR FOCUS. Of the top five funds Morningstar ranks in the group in terms of three-year load-adjusted total returns, Icon Financial (ICFSX) has the clearest focus on bank stocks. In that category, Fidelity Select Brokerage and Investment (FSLBX) and Aim Global Financial Services (GFSBX), with 18.7% and 16.8% annual returns, respectively, edge out Icon's 14.5%.
Icon's top holdings, however, give it more of a banking focus. At the end of last year, the fund's No. 1 and No. 2 holdings were in S&L Downey Financial and Charter One Financial, which respectively account for 11.6% and 7% of its portfolio. Southtrust and US Bancorp were also large holdings, representing 5.9% and 5.5% of the fund's assets, respectively. Icon Financial is off 0.4% so far in 2001. It posted a spectacular 50% total return in 2000.
If you're worried that it's too late to cash in on the bank rally, take heart: The sector still has some good plays left, and Greenspan may not be done weaving his special brand of magic for bank stocks. Anderson teaches journalism at the City University of New York. Follow his twice-monthly Sector Scope column, only on BW Online