The days of banks stocks in general outperforming the market has passed, according to Thomas Brown and Frank DeSantis, analysts at Donald son, Lufkin & Jenrette Securities. Corp.
From now on, a select group will outperform the market, while the rest toddle along. This two-man team, which has worked together for six years, may be on to something.
The analysts said their recommended list of seven banks is up 21%; The American Banker index of 225 banks is up 9.6%.
Their top three picks: Citicorp. Bank America, and Bank of Boston, each of which can rise 20% more this year, the analysts believe. The rest of the list: Shawnut National Corp., Norwest Corp., Signet Banking Corp., and Wells Fargo & Co,
Mr. Brown and Mr. DeSantis like banks with declining credit costs, productivity gains, or unique franchises. And they like "transformations," banks that will earn more in the future than their history would indicate.
Q.: Your top three picks seem pretty diverse. What's the investment theme?
BROWN: We think that one of three factors will drive earnings. Either there are declining credit costs, productivity improvements, or a bank as a unique franchise. Typically, our picks have a combination of those factors.
We are trying to avoid companies whose 1994 earnings growth is dependent on net interest income growth.
Since March, we've been saying that investing will get tougher and more selective. The days when the group outperformed the market by 40% a year, as it did for the past two years, are over. Now, 20% outperformance for a single company will be great.
As of last Friday's close, the S&P 500 was up 5.9%. The median bank of the 55 we cover was up 6.2%. But the average gain was 12.2% you are getting disproportionate returns out of certain stocks and we expect that to continue.
Q.: Citicorp, your top pick, has already had a great year. Is there still room for the stock to run up?
DeSantis: A year ago, the biggest objection to owning Citicorp was the credit risk. The year before that, people thought management couldn't deliver on the five-point plan. Today, the biggest objection is the stock is up.
You can't have a rearview mirror focus to own Citicorp stock. The prior price performance is no indication of anything. The company is fundamentally different today.
Its core earnings as a percentage of average assets is higher today than it has ever been. The management's perspective is entirely on cutting costs and realigning the relationship between the cost base and revenues. It is what we call a transformation.
The reason that's important is that Citicorp will earn more than people anticipate. In the past, Citicorp hasn't managed more than a 70-80 basis point return on assets. By the end of 1994, that will be 110-120 basis points.
In 1992, Citicorp story was one of core earnings going significantly higher because they cut the cost base. The company went from earning $4.7 billion on a pre-tax, pre-credit basis to earning $7.2 billion.
What's happening now is credit costs, which peaked by early 1992, are declining and that is driving earnings higher.
If you took Citicorp's core earnings today and put on a normal credit load, you would have a company that would earn $5 a share, fully taxed. And the stock is around $33.[It traded at $33,625, up 62.5 cents Wednesday afternoon.] Our one-year price target is $50.
Q.: Are you concerned about the management, which got them into trouble in the first place?
DeSANTIS: The biggest risk in owning Citicorp stock is the management's potential complacency. They've had a certain amount of success, the stock price is up, and they could go back to the old way of doing this - spend $2 today to earn $1 Tomorrow.
They've cleaned house in the upper echelon of senior management. The chairman is the same but there's a new head of retail, corporate banking, real estate, credit cards, mortgages, and a new ahead of the branch system.
Q.: What happened at BankAmerica? Were expectations too high or did the bank stumble?
BROWN: It's been a combination. The deal with Security Pacific was announced in August 1991. The euphoria, ourselves included, about the attractiveness of that deal was too optomistic.
Our earnings estimates were so far off. I don't want to talk about it. Back in August 1991, we estimated that in 1995, BankAmerica would earn $8 a share. Now, our 1995 estimate is $7 a share.
Despite the fact that the earnings have been a disappointment since the acquisition, I still think BankAmerica shareholders are better off with the Security Pacific acquisition than without it. I suspect in 1994 that the new BankAmerica will earn more on a per-share basis than BankAmerica would have without the acquisition.
BankAmerica's stock has been flat around $45 for 12 months, [It traded at $47.50, up $1.25 Wednesday afternoon.] But I think we are going to see $70 within 12 months.
Q.: Isn't Bank of Boston's turnaround already realized in the stock price?
BROWN: The turnaround is over. But the stock is controversial. It went from $7 to $30. But this is a transformation. We see Bank of Boston going through a change and it will earn much higher return on assets than it has historically. This should be a $40 stock in 12 month. [The shares traded at $24.25, off 25 cents Wednesday afternoon.]
DeSANTIS: Look at the balance sheet composition now versus five years ago. It is much more core funded, international, and consumer oriented. The balance sheet is telling you it is capable of doing much better than it has in the past.
But the market doesn't want to believe it. Historically, those are the ingredients you need for a successful investment. BROWN: In the future, you have to do more analysis on individual franchises. You can't just own a New England bank and think it is tied to New England. Bank of Boston has a national lending business and international business.
Only 50% of its earnings come from New England, 30% from the U.S. outside of New England, and about 20% from Latin America.
One of the things we like about Bank of Boston is that niche in Latin America. It is the largest foreign bank in Argentina and the third-largest in Brazil. It makes over $100 million in its Latin American subsidiary.
Q.: You first spoke about the industry being overcapitalized in the past and the need to boost dividends a year ago. Are you satisfied with the progress banks are making on that front? BROWN: Dividends have grown 18% since then. But it isn't enough. The equity ratios in this industry are so high that the growth in retained earnings is outpacing the growth in earnings. So the return on equity will begin to head down.
To go along with too much capital is too much loan-loss reserves. Either banks are mispricing the product or they need to bring down the level of reserves, which will create more equity.
SunTrust is a good example. I think the world of their management team, but I don't understand their views on capital. They have high equity ratios, they're generating equity ratios, they're generating equity internally at a high rate, and a $1 billion unrealized gain in Coca-Cola stock. If you add all that up, they are inefficiently using shareholder equity.
I can't believe with the equity ratios being as high as they are today that this won't lead to price competition on loans. There's already been a decline in spreads for commercial loans in the past year.
A number of the poorly managed companies will make illpriced acquisitions because the extra capital will burn a hole in their pocket.
It's the return on equity that matters to investors. The days when we rewarded companies with higher multiples because of higher equity ratios are gone.