Dennis F. Shea, regional bank analyst with Morgan Stanley & Co., recommends that investors remember the three B's when buying bank stocks: BayBanks Inc., Boatmen's Bancshares Inc., and Bank of New York Co.
BayBanks and Bank of New York stand to benefit most from falling loan-loss provisions and other credit costs, while Boatmen's is a good bet to substantially boost revenues in the future, he said
Mr. Shea joined the brokerage firm in 1985 after spending five years as a vice president and manager of corporate finance with Mellon Bank Corp.
He started his career at Morgan by issuing sell" recommendations on six Texas banks. But he's been bullish on banks in general since early 1991.
Since 1989, Mr. Shea has been recognized by Institutional Investor magazine as one of the top regional bank analysts. He is a past president of the Bank and Financial Analysts Association.
Q.: Has the recent selloff in bank shares shaken your faith?
SHEA: I believe banks will continue to do well. My index of 35 regional banks was up 64% in 1991 and 44% in 1992.
I think it can outperform the Standard & Poor's [500 index] this year by 20 percentage points.
Q.: What's out there to make you confident?
SHEA: We are at the second stage of the bull market for bank stocks. The first stage began in October 1990, and the bell that rang at the time was that the Federal Reserve lowered rates. We had a sharp rise in net interest margins starting in early 1991 because of the wide spread between the prime rate and the fed funds rate.
In the second leg, earnings are driven by declining credit costs. That's where we are now, and we are about halfway through it.
Q.: How much further is there to go?
SHEA: Look at loan-loss provisions and all costs associated with foreclosed property in 1991 and 1992. They got as high as 23% of revenues. That's extraordinarily high.
Maybe the long-term average is 8%. What I think will happen is that credit costs will fall to 11% of revenues in 1993 and 8% in 1994.
The lower credit costs can carry the banks for a while. That's true, even if rates come up.
In this stage, you want to concentrate on banks such as Shawmut National Corp., the Bank of New York, and BayBanks - banks that have the greatest potential to benefit from the decline.
Q.: What's the last leg in the cycle?
SHEA: It's loan growth. It takes a while to see, and everyone is clamoring for it. Some banks are having loan growth, such as NationsBank and Banc One.
We've seen reasonable loan growth in the Southwest. What's lagging is the Mid-atlantic states, the Northeast, and California.
Everyone is saying we need loan growth. I don't care about it in the near term. Earnings will be fine this year without loan growth because of falling credit costs.
Loan growth comes late in the cycle. When you see too much of it, it means rates are going to rise. I don't want to see pressure on rates. I want a slow-growth economy.
Q.: During the recent inflation scare, banks said they could make money when rates rise. So what's the problem?
SHEA: You could see earnings expand in that period as spreads widen. There would be rising returns on loans and investment opportunities in securities and money markets, while deposit rates would lag.
You would get an expansion in earnings, but the stocks wouldn't respond.
Banks stocks won't do well if the next big move for long-term rates is to go to 8% or higher. Banks have shown little ability over time to push their returns on equity higher during times of higher inflation or higher interest rates.
The ROE for the banking industry has been steady for a long time at around 13% to 14%.
I think the ROE for the regionals will peak in 1995 between 16% and 16.5%. That's a cyclical peak, not a sustainable level.
Q.: Which stocks do you like today?
SHEA: I like BayBanks, which is the least understood and least followed company in my group. It is the one with the greatest chance for appreciation.
They are the purest consumer marketing company I follow - the L.L. Bean of banking.
They got a catalogue of services they sent to customers. They've got 1,000 ATMs and a branch system. They've got the consumer locked up in eastern Massachusetts. This company deals with one out of two households in the area. The stock sells at 125% of book. It has a high P/E, but how many banks will grow their per-share earnings $1 or more a year for the next few years?
Q.: Who else looks good to you?
SHEA: Bank of New York is a company that is going through a gradual change. It was an also-ran money-center bank before it bought Irving. What Irving did was give them critical mass in a number of areas, particularly processing.
The bank isn't lending as much in big dollars to big companies as it did. That's being replaced by incredibly strong retail and processing businesses.
This is a company that is going to generate 40% to 50% of revenues for noninterest businesses. The securities processing business is growing rapidly, and their competition is in disarray.
If you look at them on a retail side, they have the biggest branch distribution network in the New York suburbs. They dominate Westchester County, which is a profitable place for banks.
They are very good at cost control. I went to see them in 1985 or 1986, and they were one of only two banks that had rotary dial phones and IBM Selectric typewriters - not computers. The other bank was PNC Bank. Not coincidentally, these have two of the best efficiency ratios in the business.
Q.: What kind of banks would you recommend in the third leg of the rally?
SHEA: I look for value banks or cheap stocks, or companies that can grow revenues rapidly without taking extraordinary risks.
Boatmen's Bancshares particularly has been a wonderful company. I like them today, too.
People have a prejudice against Boatmen's because it did acquisitions between 1984 and 1988 that were very dilutive to earnings. They were done under a former chairman.
But in 1990, they did the most important acquisition for them, buying Community Federal Savings and Loan, a failed thrift in St. Louis, for $27 million. They got 200,000 household accounts. Plus, Community was the disruptive pricer in the market.
Boatmen's bought the third-largest banking company in Oklahoma. It bought the largest healthy thrift in Arkansas. That deal alone adds 4 to 5 cents per share per quarter to Boatmen's earnings.
It got into New Mexico with SunWest Financial. The deal was thought to be modestly dilutive to earnings. But I thought it had a very good return on investment.
The icing on the cake is that Boatmen's has a very large and incredibly profitable trust department that's run like an independent money management company. It generates about 15% of the bank's earnings.
People said the bank could never earn over $4 a share. It will earn close to $6 this year.
The stock has relatively low price-to-earnings and price-to-book [ratios] and a relatively high dividend yield.
Q.: Which of your picks hasn't done well this year?
SHEA: Amsouth Bancorp. hasn't done as well as I hoped. I put it on my "buy" list early in the year on a dip. It's flat so far.
And Banc One Corp. hasn't done well either. I recently dropped Banc One to a "hold" and upgraded Norwest, which I think can be a $36 stock in 12 months.
Q.: Is there any stock that you've continued to recommend since you turned bullish in 1991?
SHEA: I still recommend SunTrust. The stock trades at 2.5 times book. But if you give them full credit for the Coca-Cola holding, that's another $8 a share.
That means the stock trades at 1. 65 times book for what is arguably one of the best-managed banks in the industry. I've always billed them as a stock you can own and go home and sleep well. The price moves glacially, but glacially up.
