The price/earnings ratio, esteemed as one of the most basic valuation tools at investors' disposal, is telling a pretty confusing story about the banking sector these days.
It's hard to escape the conclusion that current P/E ratios make large banks look inexpensive relative to small and midcap ones, even though many analysts argue that earnings prospects favor the large ones. Even underperformers are being rewarded.
As usual, mergers and acquisitions are complicating the valuations.
"You've got multiples on top of each other, because investors want to play the M&A game," said Jason Goldberg, an analyst with Lehman Brothers.
Investors "buy those names whose performance has lagged on hopes they get taken out at premiums," he said. "At the same time, they are scared of the larger banks who do the buying, and are selling those stocks."
The result? "We've had the least deviation we've seen in the last four years between outperformers and the bottom performers," Mr. Goldberg said. "Clearly there are some names that are trading ahead of their operating potential."
Tom Michaud, a vice chairman at Keefe, Bruyette & Woods Inc. in New York, said the same phenomenon holding up some banking companies is dragging down some of the largest, particularly Bank of America Corp. and J.P. Morgan Chase & Co.
"They're both doing mergers, and there is integration risk," he said. However, "as these companies execute, their P/Es ought to get better," and "we think they will probably have better than average earnings per share growth."
Gerard Cassidy, an analyst with Royal Bank of Canada's RBC Capital Markets in Portland, Maine, said there has been a "perverse" reaction to some banks' struggling to meet earnings targets. "Their stock prices actually go up rather than go down, which would normally be the case, but because of the takeover speculation, everyone thinks they are takeover targets."
Mr. Michaud said the deal pace in the first quarter, the fastest since 1997, has supported stragglers as well as smaller sellers.
Bank of America's recently completed deal for FleetBoston Financial Corp., followed quickly by JPMorgan Chase's deal for Bank One Corp., supported the market valuations of underperformers like KeyCorp, Comerica Inc., PNC Financial Services Group Inc., and SunTrust Banks Inc., he said.
But in transactions other than those two, the sellers have been small banks. "That has attracted investors to small-cap stocks, thinking that the age-old strategy of buying takeover bank stocks as the industry consolidates is back," Mr. Michaud said.
That strategy has its weaknesses.
"I have seen more disappointments then successes with respect to trying to guess which companies are likely to go," said Gary Townsend, an analyst with Friedman, Billings, Ramsey & Co. Inc. in Arlington, Va. "You can buy something that perhaps needs to be acquired, but for whatever reason - either you haven't a willing seller or you can't find the right buyer - it doesn't happen."
Among the small and midcap banks, Mr. Townsend prefers companies with "advantages that will take them and their share price farther regardless of whether they are acquired - and if they should be [acquired], then that's even better."
But his firm is leaning toward large-cap banks for now, and that is a popular choice these days.
"The large caps are the ones that have earnings leverage," said Jeff Davis, an analyst with First Tennessee National Corp.'s FTN Midwest Research in Nashville. "They are the ones with hidden values in the private-equity portfolios. They are the ones that have credit costs coming down, and they are the institutions with the market-sensitive revenue."
Some of those large companies look cheap.
When the market closed April 6, Bank of America's share price divided by its earnings over the last year was 11.5, the fourth-lowest among the largest 100 banking companies, according to data from SNL Financial LC in Charlottesville, Va.
National City Corp. (10.3) had the second-lowest ratio. Other large names near the bottom included JPMorgan Chase (12.8) and U.S. Bancorp (13.9). Wachovia Corp. (14.7) and Citigroup Inc. (15.3) were lurking near the lowest quartile. In the future, interest rates are likely to trump merger speculation as the major factor affecting valuations.
"You will be hard-pressed to find one commercial banker around this country who won't tell you they'll make more money with rates up a hundred basis points," Mr. Davis said.
That's because an increase in the federal funds rate would bring up the prime rate as well, expanding lending margins. And because a rate increase also implies a healthy economy, banks presumably would have a higher volume of products selling at that higher margin.
While moderate rate hikes clearly favor the asset-sensitive banks, they tend to put small banks at a disadvantage.
The small banks are "more reliant on mortgage banking and mortgage-backed securities," Mr. Goldberg said.
According to Mr. Davis, the first 100 basis points may help banks, but if the Federal Reserve Board "is going to do 200 or 300 basis points in a year, that tends to create some issues."
Mr. Cassidy said banks with large securities portfolios are particularly vulnerable, since rate increases would damage portfolio values and show up as a reduction in capital. Though regulators ostensibly do not deduct those losses in assessing capital, the magnitude of the unrealized losses could spook them anyway, he said.
Depending on how high rates rose, asset durations could extend beyond liability durations and squeeze margins, he said.
Investors may not want to walk the fine line between a just-right and a too-much rate hike, and that may be appealing to contrarians.
"The usual angst that presents itself when rates rise could be a terrific buying opportunity," Mr. Townsend said.
