The banking industry is in decline, said Judah Kraushaar, an analyst with Merrill Lynch & Co.

Mr. Kraushaar sees significant overcapacity in the industry and less regulated competitors eating banks' lunch. Without the fillip exceptional net interest margins, it is questionable whether most banks could earn acceptable returns on shareholder equity, he said.

Those that can generate high ROEs are the best bets, he said.

While Mr. Kraushaar is far from bullish, he and his team of Merrill analysts, including Sandy Flannigan and Livia Asher, like J.P. Morgan & Co., Mellon Bank Corp., First Union Corp., Fleet Financial Group, and National City Corp.

The last two have been labeled "fallen angels" - stocks that have tumbled from investor grace.

Q.: In the past, you have been more bearish than many analysts, but in recent conversations I have noticed signs of bullishness. Am I reading you correctly?

KRAUSHAAR: Bullishness may be a slight overstatement. I think we are a tad more constructive on the group, but I'm not prepared to say this is the time to have an overweighting in bank stocks.

We were very concerned from the second half of last year through the spring of this year that there was too much optimism about bank stocks. Great spreads aside, this is still not a great business.

A large number of investors who had not been in these stocks for years, if ever, were playing them for an accelerating-earnings story. We felt uncomfortable that that story was sustainable.

Q.: So why the newfound confidence?

KRAUSHAAR: The issue of margin sustainability is out in the marketplace. The improvement in credit costs has happened faster and more significantly than I expected. I feel comfortable that some managements are getting more flexibility to manage their earnings by drawing down their loan-loss reserves.

I was concerned about a real resurgence in inflation. Now, it is difficult to see inflation coming back in a hurry.

As long as that remains the case, I think interest rates will stay under control. So being in financial companies, and banks in particular, offers good relative earnings performance. And bank stocks are about 10% below their previous peaks.

Now the question becomes, can you get a new burst of enthusiasm, a new type of buyer or theme that can push the stocks higher? I'm still cautious on that front.

Q.: So what do you look for?

KRAUSHAAR: We like companies that can differentiate their earnings growth and return-on-equity performance going forward.

These companies have to do least one of the following things right.

They either have to have a decisive expense advantage, especially if they are in commodity businesses.

Or they have to have unusual revenue-generating possibilities. That comes from having niche businesses that they got into early and which have some entry barriers.

Both of these types of companies, however, have to show discipline in making acquisitions. They can't overpay.

Q.: So, who do you like?

KRAUSHAAR: We like one money-center bank, J.P. Morgan, which we feel is a diffentiated-revenue story, and four regional banks: Mellon, First Union, Fleet, and National City.

Mellon is also a differentiated-revenue generator. The rest have material cost-reduction opportunities that have not been recognized in the marketplace.

Q.: Why Morgan?

KRAUSHAAR: For the two-year period ending in December 1992. J.P. Morgan was one of the worst-performing bank stocks.

In the past two years, Morgan has pursued an aggressive strategy to shift its product mix. There were heavy costs associated with that. It spent heavily to build a lead in derivatives, to broaden the emerging-markets franchise, and to develop full-fledged underwriting capabilities.

Morgan has completed the bulk of its spending to get into these nontraditional products. Now the payday is at hand.

In the second quarter, even if you took out trading and other market-sensitive income, the bank had close to 10% revenue growth. That's the high end of the industry.

This company can demonstrate a fully-taxed 17% return on equity on a long-term basis. The stock is trading around $72. 1 think this company could be a better than $105 stock by the end of 1994.

Q.: How about Mellon?

KRAUSHAAR: Mellon was especially aggressive in addressing credit problems early. But there is still a drag from credit costs that is masking a very high ROE. Over the past two years, if you stripped out the credit costs, Mellon has demonstrated a better than 16% ROE in its basic businesses.

This is also a company that has been in the forefront of shifting its business mix from spread-related to fee-based income. The acquisition of the Boston Co. accelerated that. Before some expected divestitures, noninterest income for Mellon will be 50% of revenues. That is nearly twice the industry average.

The average bank share trades at 170% of book value. Mellon is about 140% of book. Our price target is the near $80 by the end of 1994. [Mellon shares were trading at $56.50 Thursday afternoon.]

Q.: Is Fleet a classic "fallen angel?"

KRAUSHAAR: Fleet was an analyst favorite through most of the 1980s. Now the stock trades at 1.55 times book, below the group average.

Investors were worried about the New England economy, the publicity around the finance company, and the value of the mortgage company, which has been hurt by a step-up in refinancings.

But what the market has not focused on is that the company has shifted gears and is focusing on what it must do.

Fleet a year ago was among the first banks to pursue the bulk sale of bad assets. It has announced a meaningful expense-reduction program. It is making headway in integrating the Bank of New England. And it is working its way through problems at the mortgage company.

Fleet will emerge as a low-cost producer. It also has an unusual diversification of its franchise out of traditional banking and has geographically diversified out of New England.

Our view is that Fleet two years from now will demonstrate an ROE north of 17% and will no longer trade at a discount to the group. [The company's ROE in the second quarter was 14.08%.] Our 12-month price target is upper 40s.

First Union is a similar story: cost reduction, nontraditional earnings stream, and an inherently high ROE. First Union has been misunderstood because of the economics of its acquisitions in the past. Our price target is around $65 by yearend 1994. [The shares were at $43.625 late Thursday.]

Q.: National City seems to be another company that has fallen into disfavor.

KRAUSHAAR: National City used to be a high performer and a low-cost producer. Then they took their eyes off the ball. They suffered from two large acquisitions they made in the last five to six years. What I like about this company is that it's waked up to the fact that it's fallen from grace.

In the last 1 1/2 years, management has worked diligently at cost cutting. I think reported expenses will be flat in 1993 and 1994, which means earnings will probably grow to the tune of a 15% compound rate, without having to rely on declining credit costs.

National City's ROE will be back to 17% or 18% in 1993 and 1994. [The company's return on equity in the second quarter was 14.80%.] This should be trading at mid- to upper 30s by 1995.

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