It won't be as easy to make money on bank stocks this year, according to participants in American Banker's Analysts Roundtable.
Analysts at the quarterly session said that although the economy remains favorable to banking, the stocks already are at a high level. Banks have already wrung what benefits they could from cost cutting, the analysts said, so now the ability to generate revenue could become a key determinant of success.
Consumer credit quality continues to be a concern. Still, given credit card profitability, the analysts said it was possible that some major banks could resume building up their credit card businesses as the year goes on.
Indeed, shortly after the discussion took place, Banc One made such a move by agreeing to buy credit card specialist First USA Inc.
Participants included Judah Kraushaar, of Merrill Lynch; Catherine Murray, of J.P. Morgan Securities; Steven Berman, of Stein Roe Farnham & Co.; and Lawrence W. Cohn, of PaineWebber.
What do you each foresee in the year ahead, and what are your top stock picks?
MURRAY: I expect banks' earnings per share to grow about 10% in 1997, with the better-performing banks posting EPS growth of 10% to 13%.
The biggest challenge for the industry will continue to be slowing revenue growth.
NationsBank and Bank of America are my top two picks. With NationsBank, I'm working with a 12- to 18-month price target of $145. It's my most aggressive price target.
We think we'll continue to see multiple expansion for NationsBank, especially on the '98 EPS, due to strong fundamentals, continued rigorous capital management, and benefits from the Model Bank project. That initiative is going to help limit operating expense growth.
For Bank of America, I'm working with a 12- to 18-month price target of $125. We expect above average EPS growth to be driven by continued restructuring of the business base and more rigorous management of the balance sheet.
BERMAN: The economy-with 2% to 2.5% real growth and, say, 3% inflation- provides a fairly favorable background for bank stocks. I think that rates could go either way-up 50 basis points and down 50 basis points from here. I lean toward lower rates as we get toward the middle of the year. That would set a very reasonable background for the stocks.
Bankers Trust is one of my strongest recommendations. The company had a strong recovery in 1996, and 1997 will show further progress. Returns in 1997 will be subpar, however, I foresee the potential of a number of their businesses all coming together and having pretty good years in '98. I think it's one of the cheapest stocks out there, so that's my first choice.
Another pick is Citicorp, because of its unique global franchise, its solid long term earnings prospects, and its top management, which appears intent on running the company for earnings consistency and investment performance. Citicorp is spending quite a bit of money in the emerging markets to deepen this franchise and remain competitive with local financial institutions as these countries advance. Also, not many companies have returned $4 billion to shareholders in the past year in the firm of a buyback and dividends.
Chase is another stock which has been particularly hard hit. When I look at the spectrum of choices, it's selling about 10 times '97 earnings-not '98 earnings, but '97 earnings. So I think that's a very cheap stock considering that the company is positioned for earnings growth in the mid- teens for 1997-98.
COHN: It's going to be a lot harder to make progress and move down expense ratios this year, as compared with prior years, given the slow rate of growth in revenues. Commercial provisions have been depressed for a while because of big recoveries on commercial real estate. That well is not infinitely deep, and we've seen some signs already that recoveries are starting to tail off. We think we'll see more of that in '97, and that'll put some pressure on provisions.
Our favorite stocks, then, tend to be institutions where there's clear- cut revenue growth, and those are Bankers Trust and First Union.
We like Bankers because we think that low interest rates, or relatively low interest rates are going to continue at least through this year. The junk bond market is booming. Bankers is well positioned in the low investment-grade business.
First Union has invested substantially in developing a strong capital markets capacity for serving middle market customers. They've shown terrific growth in revenues in that business over the last year or so, and we think that's going to continue.
KRAUSHAAR: It's getting increasingly difficult to identify companies that we think will have significant positive earnings surprise potential this year. But having said that, I do agree with Steve's point of view, that it's probably a reasonable bias to look for lower interest rates as time goes by.
We're really focusing on companies that we think have decisive cost- advantage, or are lucky enough to be riding significant nonbanklike niches, which are high return and high growth in nature.
One company that I think represents the consummate restructuring story, and where there's still some meaningful, positive surprise potential, would be Chase Manhattan. By several measures, Chase ranks as the most attractively valued stock in our universe by a long shot.
The other three companies I'd recommend are really the franchise-shift stories. They would be, in order of preference, Bank of New York, Republic New York, and Citicorp. Each three of these companies has a significant, unusual high return, high growth business franchise which is growing in importance as a share of total earnings.
In the case of Bank of New York, it's processing and trust. In the case of Republic, it's private banking; and in the case of Citicorp, it's the emerging-markets consumer business.
What's the story going to be this year on the merger front?
KRAUSHAAR: I think we were all a little surprised how meager the activity got last year, but that's not going to be a permanent state of affairs.
I think there's going to be a tug-of-war between many smaller or midsize (banks) that we think are going to be increasingly overwhelmed by some of the challenges of scale in investment requirements. It's going to really come down to the wisdom of the management and boards of these companies, whether they take an honest sense of their outlook and determine what's best for the shareholders.
The danger for investors is to assume a willy nilly period of merger and acquisition activity, where all kinds of companies start selling. The risk would be that many of the names on many people's takeover lists have been there for a decade, and will be there in the next decade, but the underlying franchise value may start to erode at a quickened pace.
COHN: We expect another slow year in 1997. The industry is earning close to record returns on equity. Loan losses are low. This is not an industry that's feeling a lot of heat these days, and the result of that is that it's difficult to motivate managers to sell.
A lot of the major transactions that took place in the '94-'95 time frame were institutions that had what we call "near-death experiences" in 1991, and were really motivated sellers.
What we need to jump-start consolidation again, in our view, is a good old-fashioned recession that shakes boards' and managements' preconceptions and starts to bring a lot of these institutions around to understand that they're better off in a larger home.
MURRAY: I'm not sure we need a recession. I would agree that it's likely to be a slow year, especially at the beginning of the year. But what could propel consolidation would be difficulties in finding the resources to invest in technology and product development. That's going to be an increasingly difficult issue for banks, as revenue growth slows through '97.
So I think that by the end of '97 or '98, we're likely to have enough banks suffering enough pain that they're likely to discuss their options, including selling.
I would add though, that given the current returns the banks are realizing, it is more likely that the banks look to strategic partners for both technology and product development. And if we see more strategic alliances formed, that would slow the rate of consolidation in the near term.
Do you believe credit quality deterioration will scare big banks away from the credit card business, and the credit card specialists will continue to take market share?
COHN: The fact of the matter is that the returns in credit card business for large credit card issuers is still awfully good, despite really much higher chargeoff rates than any of us would have thought were possible two years ago.
So the fact that this is an ROE business in the high 20s instead of the mid 40s, it's still a hell of a business-and monolines, in particular, are certainly going to continue to invest in the business.
BERMAN: I think it's possible that we could see some of the big issuers- Citicorp, Chase-become more aggressive in their solicitations. I could be wrong on that, but I think that they are trying to get themselves comfortable with what's going on in the credit side, and I then they will want to protect their franchises more agressively.
They have been fairly quiet in terms of an active response to the challenge of the monolines, but we suspect this may change soon.
Do you think the losses may have peaked or are about to peak on the consumer side?
BERMAN: I don't sense that. It was supposed to peak late in '96. It has not, and I would say, late '97 is the first chance. I would say we're up- going to go up for both the fourth quarter, first quarter, and second quarter.
KRAUSHAAR: That's very much what I'm hearing from the companies, that we had a little plateauing in the third quarter, and many of us thought it was a seasonal distortion or impact, but what I'm sensing from checking with my companies, is to expect a reacceleration in the rate of losses.
COHN: You can't get any bank management to say when they think the next peak is. They've tossed in the towel on forecasting that for the time being.
A number of the bankers in the mortgage business say the profits are evaporating there fairly quickly. Is declining mortgage profitability a big issue.
COHN: I don't think any of us could point out a major mortgage bank acquisition that worked as forecast. The mortgage business is a lot tougher business than most managements expected.
There's an industry where there are no barriers to entry, there's a tremendous amount of excess capacity and spreads are under a lot of pressure.
BERMAN: Norwest is quite upbeat about their mortgage business. No?
MURRAY: I think Norwest expects to get efficiency gains and productivity pickups from consolidating Prudential and Norwest Mortgage and from more automated laptop application-taking techniques that should bring down up- front costs. So I think they're still realizing productivity gains. They're the largest originator in the industry.
BERMAN: There's a technology and a scale business if ever there was one.
MURRAY: And they're reaping those benefits.
Are banks going to regret providing so much credit to noninvestment grade companies?
BERMAN: It would not surprise me if, over the next year or two, we find some leveraged deals that don't work out. It's a sluggish economy. But I do think that overall risk management and portfolio diversification in terms of what these banks retain for their portfolios has improved. They're approaching it in a smarter way than they had the last go-around.
COHN: We take a more cynical view of the world. Our view, is bankers never learn.
Our economy is strong enough that assets are not a problem now, and we don't see it as a problem in '97. On the other hand, pricing and quality differentials are down sharply, and talking with credit officers around the country I hear the same sorts of things today that I heard in 1988, in 1989-We're seeing deals that don't make sense.
The reality is, as bank investors we're buying blind pools, and so, when a recession comes, we're going to find out who, in fact, has done a good job and who hasn't. History does say that strong lenders tend to stay strong lenders, and weak lenders tend to stay weak lenders, but every cycle we find some new weak lenders.
KRAUSHAAR: Bigger banks are now in the business of originating and selling credit, and it's the smaller companies which step up and take the disproportionate amount of risk and buy the paper, so that in the next cyclical downturn, where the pain will be borne will be very different from in the past.
It may be pushed down into the system, so that the bigger banks may do a lot better.
MURRAY: It's still very difficult to get a good risk-adjusted return on high quality corporate lending. Therefore, if these banks continue to move down the credit spectrum, and take on more credit risk, hopefully, they'll get paid for the risk, so that they've got the ability to create the reserves in the process.
Is there anything banks are overlooking that could cost them later?
COHN: I just wonder if at some point, the industry doesn't start to ask itself if it hasn't underinvested, and we go through a period where expenses accelerate because the slow rate of growth in revenues that we're seeing today, may in fact, very well reflect the lower investment that's taken place in years past.
I know that there are managements that are worried about that, but it's not clear to me who is out there who is willing to really step up and say, "You know what? We're going to sacrifice this year's ending growth.
"This year, earnings are going to be flat or down a little bit. We're going to have to spend some money to build the franchise." The problem, I think, is that even if that's what the case is the market will actually crucify the first institution that does that.