Among Banks, Go for the Giants

S&P's Evan Momios likes the diversified business models of big institutions such as Bank of America, Citigroup, and US Bancorp

After a slow start in 2005, banks have done better than the Standard & Poor's 500-stock index in the last two months. That's the report from Evan Momios, bank analyst at Standard & Poor's, who attributes the improvement to a lessening of inflation fears and a drop in energy prices.

But within the sector, Momios has a clear preference for larger-cap institutions because their business is more diversified. Among the big banks he covers, he has a strong buy recommendation on Bank of America (BAC ), Citigroup (C ), and US Bancorp (USB ). These three "are all reasonably valued, have business models that are diversified by product and geography, and offer good dividend yield," he explains.

The current problem with smaller banks, he says, is their greater dependence on revenue from lending operations and from the spread between short- and long-term interest rates, which is unusually narrow at the moment.

These were a few of the points Momios made in an investing chat presented May 24 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at aol.businessweek.com/chat

(Evan Momios is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts.")

Q: Evan, in this still-confusing market, how have the banking and financial services stocks been faring?

A:

I will focus on the bank stocks. The year started very poorly for this sector. Banks were significant underperformers in the first quarter until the Mar. 22 meeting of the Fed. Since then, they have outperformed the S&P 500 as inflation fears have subsided and energy prices have come down.

Q: So if the Fed continues its measured pace of interest rate hikes, how will the bank stocks react?

A:

We have said that measured interest rate hikes should not threaten the profitability of American banks. And we have been more optimistic on larger-capitalization diversified banks and less optimistic on small- and mid-cap banks.

Investors should not only look at what happens to short-term rates that are determined by Fed policy but they should also consider what happens to long-term rates that are determined in the marketplace. We believe long-term rates pose a risk because, in our view, they are extremely low at current levels, which is contrary to what everyone expected one year ago. Particularly for smaller banks, the differential between long- and short-term rates is a primary driver of profitability.

Q: What big banks do you prefer? Any buys there?

A:

We currently have strong buy recommendations on three larger-cap banks that we believe are all reasonably valued, have business models that are diversified by product and geography, and offer good dividend yield. The three are: Citigroup, US Bancorp, and Bank of America.

Q: Do you have any strong buys among stocks you cover beyond those three?

A:

We have a smaller regional bank that our analysts like. I do not follow it personally. We have been positive -- with a strong buy recommendation -- on Commerce Bancorp (CBH ). Among savings and loans, we have a strong buy recommendation on IndyMac Bancorp (NDE ). Additionally, we like, and have a strong buy recommendation on, Capital One Financial (COF ). Traditionally a consumer lender with a focus on credit cards and auto lending, it earlier this year announced the acquisition of Hibernia (HIB ), which is a regional bank operating in Louisiana and Texas. And, since we're talking about consumer lenders, we also have a strong buy recommendation on MBNA (KRB ).

Q: Anything on the next level down, the buy recommendation?

A:

There are plenty of those.... There are 16 commercial banks with a 4-STARS (buy) rating [in S&P's Stock Appreciation Ranking System, or STARS]. Those are AmSouth Bancorp (ASO ), Associated Banc-Corp (ASBC ), Cathay General Bancorp (CATY ), City National (CYN ), Comerica (CMA ) (recently upgraded), Cullen/Frost Bankers (CFR ), East West Bancorp (EWBC ), Hibernia, JPMorgan Chase (JPM ), Mercantile Bankshares (MRBK ), National City (NCC ), PNC Financial Services (PNC ), South Financial Group (TSFG ), UCBH Holdings (UCBH ), UnionBanCal (UB ), and finally Wachovia (WB ).

There are two thrifts -- the first is Sovereign Bancorp (SOV ). And in the same category, there is one that is a mortgage insurer -- PMI Group (PMI ).

Q: What is it that makes you think less of small and midsize banks in this environment?

A:

What is different about small- and mid-cap banks compared with larger-cap banks is the high percentage of revenue generated from lending operations and spread management. Larger banks have diversified models, and they do not rely as much on spread management. There is nothing wrong with relying on spread management when the yield curve is steep (or the difference between long- and short-term interest rates is great). But at the moment, the yield curve is very flat. And as a result, it's very difficult to earn attractive returns from traditional banking or lending operations.

Q: How long can community banks exist?

A:

The answer is forever. Seriously, though, it's true that the country still has a large number of banks. As a result, there has been a very long-term industry trend toward consolidation. I would say that over the last decade the number of depository institutions insured by the FDIC has declined from somewhere around 14,000 to about 8,000 recently -- still a very large number. We think consolidation is likely to continue, although in the near term the relatively high valuations of small banks will probably keep buyers from acting.

Q: Evan, your thoughts, please, on Wells Fargo (WFC )?

A:

We believe Wells Fargo is a well-managed company that has consistently generated strong revenue and earnings growth. The main issue we have on an operating basis is the relatively high reliance on the mortgage market.

As an investment, the stock has always had an above-average p-e multiple, and based on our view on the industry, economic conditions, and the housing market, we hesitate to be more positive on the stock. We have a hold recommendation, and we would not add to positions at these levels.

Q: How successful has Bank of America been in spreading its brand all over, especially since it took over Fleet?

A:

Bank of America is the American bank that has come closest to what we could call a national bank. It's the first one with a coast-to-coast retail banking footprint. The Fleet acquisition has expanded that footprint to the Northeast, which is a market area with above-average wealth, although the Northeast demographics, such as population growth, aren't as attractive as those of the Sunbelt states.

In addition to the expansion of its network, the integration of Fleet is offering Bank of America the opportunity to realize cost savings from the integration of duplicate systems, resources, etc. Overall, we think the integration is moving along as we had expected. However, we think there are other important initiatives at Bank of America, such as the expansion of its corporate and investment banking that should be in the investor's interest.

Q: Do you track any foreign banks? And if so, what are some of your picks? Any in China?

A:

I don't follow foreign banks. Standard & Poor's has analysts located in London and other international cities who do follow internationally active banks. But I am not at liberty to discuss those recommendations. What I would say is that Citigroup is the one domestic bank that is most diversified internationally, and that international markets are an area of potential growth for Citigroup.

I would also note that Bank of America recently announced an investment in China. China represents a long-term potential opportunity for the U.S. financial sector, and there have been several investments made over the past few years. But these investments are still very small to generate any significant boost in the bottom lines of any of the companies involved.

Q: Do you feel Commerce's megabranch format is a competitive advantage that will survive, or is it too costly?

A:

Commerce has been expanding by opening new branches and expanding into a new geographic market every year. Looking at the company's financials, it's obvious that this is an expensive strategy. However, the bank has been able to increase low-cost deposits at a multiple of the industry's growth rate. We believe that investors should look at both the costs and the results combined. In our view, it's deposit growth significantly above industry average that justifies the relatively expensive operating model.

Q: You referred to Commerce's deposit growth -- is it that important?

A:

In our view, it can be important. As we have discussed in previous online chats, there is more than one strategy that can lead to profitability. In the case of Commerce, it is critical that deposits continue to grow at relatively high levels, although it is reasonable to assume that as the company grows larger, the growth in deposits will decelerate.

Q: What is your opinion on JPMorgan Chase? What is the reason for its poor performance?

A:

We liked the acquisition of Bank One by JPMorgan. The integration of the Bank One franchise is ongoing, and it's a long-term process. We think, at the end, it will result in a much more balanced business model. However, we think the next few quarters will remain volatile. We have a buy recommendation on the shares of JPMorgan Chase, but we think this stock will also remain volatile until after the integration, which is still a work in progress.

Q: Do you feel now is a good time to buy bank stocks overall? If the Fed stops raising rates, do they all jump in price?

A:

It's hard to speculate on investor sentiment. What we try to do is focus on the fundamentals and focus on earnings that we think at the end drive the valuation of stocks and performance. The stocks we recommend as strong buy or buy we believe represent our best ideas. I would also remind investors of our aggressive posture on large-cap banks and our neutral posture on smaller banks and thrifts.

Edited by Jack Dierdorff

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