Bank stocks may be inexpensive right now, but it is still not time to he an aggressive investor in them, according to George M. Salem, the banking analyst at Prudential Securities Inc.
Besides the likelihood of rising interest rates Mr. Salem is also worried about crucial structural issues for the industry. Banks are confronted by both weak loan demand and weak deposit growth for the indefinite future.
The analyst thinks bank earnings will grow 11% next year, but probably be outpaced by industrial earnings growth of 20%. Among other things, that dictates his neutral stance on bank stocks right now.
But he also believes some banks around the country are well prepared to weather the problems.
Q.: How do bank stocks look to you right now?
SALEM: The bank stocks look cheap by any statistical measure, but I can't see them outperforming the rest of the stock market soon. Despite what seems to be a respite for bonds because of a fall in oil prices, I think the general path of interest rates from here is upward.
History tells us that bank stocks do not perform well when interest rates are rising. That is the basic foundation of my "hold" rating on bank stock group.
On top of that, the strength of the important bank fundamentals of loan growth and net interest margins is questionable. The absence of top-line growth at man banks is a turn-off to investors. They can't keep paying high multiples for earnings generated by declining loan-loss provisions.
There is also the fact that the growth rate of the banks' earnings is slowing just as the industrial part of the economy is finally getting some momentum going.
The bank earnings growth rate of 10% or 11% next year, and probably a few points less in 1995, will probably pale next to industrial profit growth of maybe 20% or so each year over the next two years.
Of course, if some new consensus appeared that rates could fall further, then bank stocks might come to life. But I still think they've gotten a bit tired after their three-year bull market.
Q.: Are there any momentum investors left in bank stocks?
SALEM: They were certainly the ones who brought the stocks down recently. It is hard to say when the institutional investment community will have finished selling off the bank stocks they don't want. We're probably near the end of that process now. But I still don't think it's time to get aggressive.
Q.: Are the portfolio managers you talk with still overweighted in bank stocks, or are they back to more traditional levels?
SALEM: It varies, but generally I would say they've gone from very much overweighted earlier this year to slightly overweighted now. It just stands to reason that if you were an owner of bank stocks in 1991 and 1992, you are overweighted now because many bank stocks doubled and tripled in price.
Q.: Are you still concerned about structural problems for the banking industry?
SALEM: Absolutely. We have weak commercial loan growth for the indefinite future and little or no growth in core deposits. In other words, the banks are losing market share on both the asset side and the liability side of their balance sheet. And the problems are structural. They are semipermanent.
Q.: Is the current lending slowdown part of that scenario?
SALEM: Yes. According the latest figures, commercial loans at banks fell 3% in the year ended in October. They should have been up 6% under the old rule of thumb - that loan growth should equal the growth rate of the economy plus inflation. A swing that wide is surely structural.
Q.: You recently completed a loan growth survey that you've said was less than optimistic. What did you find?
SALEM: Based on a survey of 100 corporate treasurers and financial economists, we forecast business-loan growth from zero to 5% annualized through 1994.
That assumes economic growth of 3% to 4% and inflation of roughly 3%. We expect the banks' loan growth to be less than historical trends would call for beyond next year as well.
Q.: What's behind these structural changes?
SALEM: Basically two things. Businesses are doing a better job of managing themselves more efficiently. They also have a keen desire to reduce their leverage, which is a euphemism for fewer bank loans.
These companies are utilizing many other avenues of external finance, many of which are cheaper and more flexible than banks. This year the bond and stock markets have provided access to capital.
In some cases, the borrowers are not happy with banks over rough treatment they got in 1989 and 1990. The bottom line is that banks are becoming lenders of last resort to businesses rather than primary providers of credit.
Q.: How about the outlook for deposits?
SALEM: There is an important point to make about deposits. If interest rates rise, banks face potentially large increases in the cost of deposits. A lot of money is just sitting there parked, waiting for a better deal than 2%.
If CD rates start to rise to levels that becomes interesting, say to 6%, you could see 2% passbook money shifting into 6% CDs. That would be reversal of the wonderful process that occurred over '91 and '92, during which high-rate CDs matured, went into 2% and 3% accounts and gave banks such a low cost of funds.
In other words, we could now face a significant upward repricing of bank liabilities. If banks are going to pull in money, they will have to pay a market rate, which they are not paying today.
There is a gap of 125 to 150 basis points or more between what banks are paying. Then you have to make the jump up the yield curve from the short-term rates to CD rates.
In the banks' favor, they set their CD rates themselves, rather than the market. That means they at least can lead the horse to water even if they can't make him drink. It's another troubling part of the net interest income picture for banks.
Q.: Do you think banks can lure back the funds lost to mutual funds over the past several years?
SALEM: Some, but I don't know how significant this might be. I think that once people discover a family of mutual funds, they tend to stay, trading up or down the risk spectrum as necessary among different funds. Mutual funds are the bank deposits of today.
Q.: So where do bank stocks go from here?
SALEM: The banking industry fundamentals call for consolidation louder today than ever. That is certainly the prospect in the intermediate and longer term. But right at the moment, I don't think banks are clamoring to get together.
There isn't going to be an earnings collapse for banks. There will be some earnings growth, as I've said, which will be importantly helped by reductions in loan-loss provisions. Lower provision will make up about 40% of earnings. And this could go some ways into 1995, since these reserves are essentially storehouses of earnings.
Q.: Are there are any major positives for the banks stocks?
SALEM: The bull case for bank stocks right now is very difficult to make. In order to be a bull, you essentially have to root for the economic and monetary climate to go back to where it was: a soft economy with weak corporate profits and falling rates. That combination doesn't appear to be in the cards.
The one positive for the stocks, besides the fact that they are cheap, is that the banking industry may be the best source of dividend growth of any industry in the stock market. The utilities have historically played that role, but our utilities analyst says that utilities dividend growth in 1994 will be only zero to 2%.
That should help attract income-oriented investors to the bank group. But its a mixed plus. With big dividend increases, banks are essentially telegraphing to investors that they have too much capital and it can't put it to work, that loans aren't going to growth.
Q.: Do you see the bank stocks actually underperforming the market next year?
SALEM: Right now, I'm looking for them to be market performers, since they have had their correction. But if the whole stock market experiences a correction, I would expect the banking stocks to do better on a relative basis than other stocks.
Q.: What about the interest rate factor?
SALEM: We don't think rates are going up that far, maybe 6.5% for the [30-year Treasury] long bond and 3.75% on 90-day Treasuries. If the outlook [for even higher rates] became worse, I would have to look my ratings again.
Q.: Obviously there are going to be winners and losers under your scenario. Who do you like?
SALEM: We favor the bank we believe can swim through this environment by being less geared toward domestic commercial lending and core deposit gathering.
Our single favorite stock continues to be Norwest Corp., which we think has the best characteristics for handling the scenario we see.
Norwest has major sources of noninterest income, and within its net interest income category it has Norwest Financial, which is extremely profitable. It has a diverse set of banks in over a dozen states.
As the largest contiguous banking franchise in the country, it has the best odds of becoming a truly nationwide bank over the next five years.
Q.: Any other special banks?
SALEM: We like Bank of New York Co. Its commercial loans are going down, just like everybody else's, but it has major offsets, particularly credit card lending and securities processing. That earnings stream, if spun off, could be worth 18 times earnings.
Also First Chicago Corp., where credit cards are 40% of earnings. They have a credit card company that happens to be a commercial bank. Their venture capital activities are somewhat tied to the stock market, but that is a line of business that will help them out for five, or six years.
So, they have good strategies to compensate for lack of commercial loan growth. They also have the No. 1 franchise in Chicago for middle-market and consumer lending.
First Interstate Bancorp is another favorite. They have reduced the risky assets in California and have terrific potential outside California. They also have some acquisition opportunities for large thrifts that would be nondilutive.
Q.: And you like Citicorp?
SALEM: We do recommend Citicorp. It's possible the stock might get hurt in a rising-rate environment, but the story at Citicorp is its improving loan quality and global franchise, particularly in developing countries.
Citicorp is mostly a foreign financial services company; what they have in the United States is mostly consumer. Their vulnerability to shrinking commercial lending by banks is limited.
Q.: You recently downgraded Banc One Corp. What are your concerns?
SALEM: I think they have an excessive amount of interest rate swaps right now and seem to be taking on more risk than they need. It is a distraction from the fundamentals of a very well-managed company.
Q.: Do you expect the subject of swaps and derivatives to play an important role over the next year?
SALEM: I think investor awareness of the swaps issue is up dramatically. I don't think the average investor was aware how they worked and that they might have been enhancing earnings in some cases rather than simply hedging against interest rate risk.
I think it behooves investors to understand as well as they can the interest-sensitivity equations of banks, since they differ greatly from bank to bank, and more importantly, the newer vehicles of interest rate swaps, collars, and floors.
It's especially important with rates probably rising because that's when we are going to get the interesting action.
George Salem's Picks:
TOP "BUY" RATING
* Norwest Corp.
ALSO RATED "BUY"
* First Chicago
* First Interstate
* Bank of New York