Forget moving to just a market weighting in bank stocks. Investors should be underweighted in the group next year, said Stephen Berman, an analyst with Natwest Securities in New York.
Mr. Berman turned bearish on the group back in February, one of the early birds. Like some other analysts, he worried about eroding profit margins and spotty loan demand. But more than most others, he believed there was potential for disappointing earnings.
Even so, he thinks the "big, ugly" money-centers are a way to make money, because the potential for higher-than-expected earnings is there. His only two buy recommendations: Citicorp and Chase Manhattan.
Q.: What caused you to turn bearish nine months ago?
BERMAN: We thought the stocks were expensive early in the year, and we thought there were going to be fundamental concerns that would weigh heavily on people's willingness to buy bank stocks. We thought margins had peaked and would erode. We felt that loan demand would be a disappointment. For starters, the capital markets are strong competitors to banks.
Corporations access the market instead of borrowing. The household sector and the corporate sector are reducing the debt of the 1980s. That will continue. And the sluggish nature of this economic expansion would weigh heavily on the growth in loans.
We didn't gain much comfort from the fact that people are asking what else is there to buy. They were concerned about drug and tobacco stocks. That was a positive force in bank's favor this year.
Bank stocks looked cheap, and the P/Es were less than those other groups and earnings in the near term looked reasonably good. I didn't think that was a solid reason to buy the stocks. And now there's recognition that there are alternatives.
Q.: Other analysts talk about margins contracting and sluggish loan demand, but they haven't gone bearish. What else did you look at?
BERMAN: I have a view that there is a relationship between relative bank stock performance, interest rates, and the economic cycle. When you are in the early stages of recovery, the first one to two years, it has traditionally been quite bad for bank stocks and they have underperformed the market. That wasn't true in this cycle. but it was in past cycles.
Since we came out of the recession in 1991, it has been a particularly weak economic cycle, rates have not moved up, and there hasn't been a big uptick in sales for the cyclicals.
In fact, rates have moved much lower than anyone expected, which helped banks more than usual at this stage of the recovery.
I thought that in 1993, we were going to see an improvement on the cyclical side and the prospect of at least a rise in rates. Historically, bank stocks have underperformed in the early stages of a rising-rate environment. People focus on other sectors that are more economically sensitive.
Then, frankly, I felt that earning disappointments were coming.
Q.: But so far this year, have you seen disappointments?
BERMAN: I haven't seen any. They aren't going to happen in 1993. 1 think the fourth quarter will be good.
What you are seeing today in the stock market are concerns about 1994. Banks can battle to forestall what is going on in the industry. But how long can you keep your finger in the dam?
Banks reaped the benefits of buying investment securities. They are helping earnings today, but they are wearing out.
We are seeing more price competition on loans. Rates are coming down. There's a willingness to take on credits without collateral that wasn't there a year ago. And Morgan Guaranty put pressure on other banks to cut the prime. If the economy is weak early next year, you could see banks cut their prime.
Q.: You like money-centers more than regionals in this environment, right?
BERMAN: We don't care for the regionals because of the rate environment and the stage of the economic cycle. The lower rates are more vulnerable, and that makes the regionals more vulnerable.
The source of funding for the regional banks is basically core deposits. They have been able to deliver strong earnings because they dropped deposit rates to unprecedented levels. At this point in the cycle, they don't have the flexibility to go lower.
Since April, everything has collapsed. Regionals haven't seen their April highs. With hindsight, I should have had "sells" on those stocks. Banc One is the worst-performing stock in the past two years in the industry, down 13% since the end of 1991.
Low stable interest rates are the worst possible environment for the banking industry, because banks make money trading money. They like falling rates and they can manage in rising rates. No change in rates cuts out the vigorish.
The next major move will be up in rates. All the banks in general, fundamentally, we will do better in a gradually rising rate environment.
There's a complication. Some investors in banks believe that you don't own banks when rates are rising.
Q.: Where will Citicorp's higher-than-expected earnings come from?
BERMAN: The speed at which credit quality will improve will surprise people. I think Citicorp will still build its reserves next year, not as rapidly as it has been building them. It will still have provisions for credit losses exceeding chargeoffs.
That's actually a positive at this point. We are getting companies that are dropping their reserves. which helps earnings but not the stock prices.
I think that Citicorp has the biggest bureaucracy of any money-center. It has the biggest infrastructure of any money-center. And it seems more committed to address those issues than most banks. I think that we will see positive surprises in that area.
I think there's also some potential for surprise in revenue from Citicorp. Because Citicorp isn't as dependent on North America, which is a key advantage for it and for some other money-centers. Citicorp has some businesses overseas that are growing well.
They are also a big North American bank tied into the consumer sector, which has been slow for them. The competition isn't getting any easier, but it is conceivable that if we have an economic expansion and people begin to spend more and use their credit cards more, that could generate more revenue than the recent trends could indicate.
The consensus is a little over $4 a share for 1994. We are at $4.75. We think there's potential for more than $5. My price target is $45. [Shares traded at $35.75, off 37.5 cents Tuesday afternoon.]
Q.: What's there to like at Chase, which has been sold off severely lately?
BERMAN: It had been a good performer until a month ago. It was at $37.25 on Oct. 4, up 31% this year. That was the third-best money-center performance. Now it is around $32, which is up 13%. That's still better than the market. But Chase was the hardest hit money-center. It shows a lack of commitment to Chase.
The main thing about Chase is the potential for strong earnings over the next several years. I think Wall Street's estimates are low. My estimate is $5 a share in 1994. The street is around $4.50.
In terms of value, it sells at about book. It has a solid yield of 3.5%, with the prospect for moderate growth starting next year. It has the characteristics of value and earnings momentum.
Q.: Where do the earnings come from?
BERMAN: It is a global wholesale bank, and I think that business will do well for them. They've been a laggard in derivatives and trading, but they have good distribution and good relationships. They haven't had the right credit rating to help that business. There's room for revenue momentum on that side of the business.
Look at First Chicago and Chase. Chase has the better wholesale bank.
Q.: But First Chicago is coming back into favor, and people are talking about its credit card business.
BERMAN: Chase has a bigger credit card operation, but it isn't doing as well as First Chicago's.
Chase is starting to do that now. Chase was the most severely attacked by the nonbank competition for value-oriented credit cards. They were too slow in adjusting their pricing to retain business.
I do have reservations about the management. There's a world of difference between Citicorp and Chase. Citicorp is much more willing to innovate.
My price target is $45 for next year. But I have my fingers crossed. [Shares traded at $32, up 12.5 cents Tuesday afternoon.]
