Bigger Is Better in Bank Stocks

A narrow interest rate spread is one reason to prefer the larger banks, recommends S&P's Evan Momios

If you want to bet on bank stocks, look for size. Such is the advice of Evan Momios, Standard & Poor's analyst of banking and financial services stocks, who has a neutral outlook on small- and mid-cap banks, but is positive on many of the larger ones.

The reason, he explains, is that big banks are less vulnerable to the narrowing spread between short- and longer-term interest rates -- because their revenue is less dependent on that spread.

DRAWING DEPOSITS.

  Among the financial giants Momios and S&P list as strong buys are Citigroup (C ), US Bancorp (USB ), Bank of America (BAC ), and Fifth Third Bancorp (FITB ). Momios also has a strong buy rating on a somewhat smaller institution, Commerce Bancorp (CBH ) and praises its skill at drawing in deposits from retail customers.

At the other extreme, Momios says, there is "probably the largest number of sells we have had in a while," in many cases owing to that narrow interest-rate spread and also to reliance on mortgage income. Included in the strong sell group are Huntington Bancshares (HBAN ) and Washington Federal (WFSL ).

These were a few of the points Momios made in an investing chat presented Feb. 8 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online, the chat moderator. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at keyword: BW Talk.

(Evan Momios is a Standard & Poor's 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 analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's 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, how are the banking and financial services stocks doing compared to the broad market?

A:

Today was a very quiet day for the market in general. This was mostly due to the absence of economic news. Investors were probably waiting to hear what Cisco (CSCO)had to report after today's close. Banks, more specifically, had an average day. Their performance was mixed, with no industry-specific news. The segment was relatively weak vs. the market.

Q: Is the shadow of higher interest rates still hanging over the bank stocks?

A:

The shadow will always be hanging over banks. Interest rates are important in determining a bank's profitability in more than one way. For example, what we have seen over the last few quarters is increasing short-term interest rates without a corresponding increase of long-term interest rates.

That flattening of the yield curve is primarily detrimental to the profitability of smaller banks. That is the main reason we are neutral on small- and medium-capitalization banks, and we are more positive on large-market-capitalization banks. Spread revenue is a relatively small portion of their total revenue. But, as I said, this is only one of the ways that interest rates affect banks.

Q: JPMorgan Chase (JPM ) was down again today -- should we buy more or sell?

A:

It was down today, but it was up yesterday. I don't think we should make our investment decisions looking at very short-term trends. As you may know, we have a buy recommendation on the shares. The company has been going through a very important and time-consuming integration. It has been a difficult process, but we think they're making progress toward creating a more balanced franchise.

Q: What do you think of Citigroup (C ) at this time?

A:

Citigroup had some reputational issues surfacing over the summer. The way we look at the stock, we think it's undervalued. We believe, operationally, the company has been doing well. It is very diversified, and we think it's well managed. We would take advantage of the current valuation to buy the shares, as we think their reputational issues are in management's focus. We don't see these issues as long-term problems or risks. Our recommendation is a strong buy, and we have a $57 12-month target price. The stock is paying a 3.6% dividend yield.

Q: I have a good profit in AmSouth Bancorp (ASO ). Do you see more upside in this stock without a takeover?

A:

We have a buy recommendation on ASO. Our 12-month target is $27, and the stock pays a 4% dividend yield. We think, over the long term, it can grow earnings at about 10%, which is slightly above peer levels. We like the company's geographic footprint, as well as the growth potential offered by its wealth management and commercial banking businesses.

Q: Do you have any strong buys among the banks besides Citigroup, Evan?

A:

Yes, we do. We have strong buy recommendations on a couple of credit-card issuers: Capital One (COF ) and MBNA (KRB ). Among banks specifically, we have strong buy recommendations on Citigroup, US Bancorp, Bank of America, and Fifth Third Bancorp. In general, we have a preference for larger institutions with diversified revenue models that we think can do well in a strong economy and better deal with the flatter yield curve we talked about earlier.

I forgot to mention Commerce Bancorp -- because it is smaller in market cap than the others I mentioned. We do, however, have a strong buy recommendation on CBH. We have a 12-month target of $80. We think it is a superior retail bank with a strategy that focuses on the deposit gathering we think will continue to grow earnings at average annual rates way above its peers. Another one that I would like to mention is IndyMac (NDE ). NDE is also a strong buy recommendation, but it belongs to the savings and loan sector.

Q: Are there any more significant bank mergers in process or in prospect?

A:

Merger and acquisition is a long-term trend for the banking industry in the U.S. Simply stated, there are a lot of banks in the country, and they have been consolidating for several years. For example, one week ago Citigroup announced that it was selling its life insurance business. There was a lot of speculation in reference to what smaller mid-cap banks Citigroup would go after. In general, geographic areas with strong population growth trends always attract interest.

We don't make recommendations based on such speculation, but we do have a bias toward smaller banks in high-growth markets -- for example, the Sunbelt states (Arizona, Florida, Southern California) or areas with large metropolitan markets, such as New York, Chicago. Inevitably, some of the smaller banks in those markets will eventually be acquired, but we don't have anything more specific to mention at this point.

Q: How do you think M&T Bank (MTB ) will do in the next year? Will it sell or buy?

A:

It has been a buyer in recent years. It's a very well-managed organization. We don't have a favorable recommendation on the stock -- we have a sell recommendation with a price target of $100. And we think that although it's a great company, the stock is just overvalued, in our opinion.

Q: Do you have any other banks ranked as sells?

A:

We have sell recommendations on Countrywide Financial (CFC ), Fulton Financial (FULT ), and Golden West Financial (GDW ). We have a strong sell recommendation on Huntington Bancshares. Another strong sell recommendation is Washington Federal. And a few more sell recommendations are: Silicon Valley Bancshares (SIVB ), KeyCorp (KEY ), FirstMerit (FMER ), and finally, although not exactly a bank, State Street (STT ).

Q: Is that an unusually high number of sells? Are they all for valuation reasons, as with MTB?

A:

Well, it is probably the largest number of sells we have had in a while, and it's due to a combination of factors. Valuation is always important. The flattening of the yield curve and the large proportion of revenue derived from spread management is another factor in many of these banks. And, finally, a lot of these banks have a greater-than-average reliance on mortgage income. This reliance will also come under pressure in '05.

Q: Here in New York we are seeing exotic (for us) names such as Wachovia (WB ) and Valley National (VLY ) sprout up on street corners. Is this a nationwide trend?

A:

There is a trend that has been playing out for a few years now. Some people think it cannot continue forever -- the aggressive opening of retail branches. This is exactly what you see in New York. The New York market is very deposit-rich. So, naturally, the New York market can become a target for banks pursuing the strategy we mentioned. My personal view is that although it cannot continue forever, I don't think it will slow down in '05.

Q: You gave us a fair number of strong buys to offset your sells, Evan. What about the buys on your list?

A:

The list is long -- we could go on about it all day. However, here are a few names in the larger market-cap section: JPM, Wachovia, National City (NCC ), AmSouth, New York Community (NYB ), PMI Group (PMI ), Sovereign (SOV ), Zion (ZION ).

Among smaller names, we have a buy recommendation on Mercantile Bankshares (MRBK ), Hudson United (HU ), City National (CYN ), Cullen Frost (CFR ), Bank of Hawaii (BOH ), Associated Banc-Corp (ASBC ), South Financial Group (TSFG ). I think that is most, if not all, of those with a buy rating.

Edited by Jack Dierdorff

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