With an economic environment that seems too good to be true, the inevitable question-"How long can this last?"-dominated American Banker's latest quarterly roundtable of bank analysts.
The panelists met June 27, just as the first half was ending. Bank stocks had been handily outpacing the market, maintaining a rally that began more than two years ago.
As analysts expected, the Federal Reserve's July 2 decision to refrain from tightening interest rates further buoyed investor confidence in banks. Financial stocks continue to reach higher plateaus, with solid earnings fueling investment in the sector.
The analysts were generally optimistic. Further consolidation, a benign economic environment, strong earnings, and relatively low multiples will continue to support bank stocks, making them a good investment during such heady times, the analysts said.
But they questioned the use of technology as a magic solution to revenue growth and were mixed on banks' rush to purchase securities firms at high prices. And they agreed that selectivity will be essential for success.
Still, the outlook was upbeat on an industry that seems to have left the problems of the 1980s well behind.
Participants of the quarterly discussion in New York were Yun Jae Chung of Bessemer Trust, Lawrence W. Cohn of Ryan Beck & Co., Catherine Murray of J.P. Morgan Securities. Joseph A. Stieven of Stifel Nicolaus & Co. joined the discussion by telephone from St. Louis.
Do you think the current rally in bank stocks can be sustained much longer?
STIEVEN: We believe that the industry fundamentals will remain intact for some time down the road. We've already seen some companies hit some potholes, but the overall trends for the industry will remain relatively strong.
Whether or not you like certain big banks out there, the underlying truth is that they are pretty rational and they want to make money for their stockholders.
Asset quality is close to all-time-record strong levels. Capital positions still remain very strong, allowing banks to use capital management to help push their earnings growth.
We are in a long-term trend for consolidation. We'll see lots of deals over the next 10 to 15 years.
And the relative valuations of bank stocks still are compelling. Banks are still trading at about 70% of the market multiple, and this continues to attract a lot of value buyers.
So in general we feel very good about the industry and the stocks.
CHUNG: Well I agree with Joe on bank fundamentals, but where I guess I would disagree a little bit is on valuation.
I have a sense that the traditional value buyers are not the ones who are stepping up to the plate here. I think that there has been a lot of momentum buying.
There has been a subtle rotation, and so the bank valuations, particularly for the regional banks, don't look that compelling.
I do like Chase and Citicorp though, because I do think that the risk/reward is pretty good there. Citi and Chase both have lagged the market year-to-date, based on what we believe to be near-term concern.
COHN: Looking at the big-cap stocks first, the fundamentals continue good, but the industry is really treading water. Revenue growth is slowing down. Asset quality is exceptional, buyback programs are in place-but all of that has been true for the last year.
At the margin, there is nothing going on to accelerate earnings growth, and in fact, quite the contrary. We are starting to see signs that earnings growth is slowing down as revenue growth slows on a consecutive quarterly basis. Stock prices are up, and that means that you are buying back less and less stock relative to the base each quarter.
So we are in a fundamentally very sound period for banks, but at the same time, when you start looking at the rates of change on the stuff that counts, it doesn't look like that is moving particularly in the right direction.
On the other hand, the big looming negatives that you worry about in the banking industry just aren't there, so you don't have anything that is going to taint this industry. But banks clearly have not been the barn burners thus far that they had been in the last couple years.
I am firmly convinced that one of the reasons that revenue growth is as slow as it is in this industry is because the industry has underspent. This mania with pulling down expense ratios has led the industry to not invest adequately in the future, and as a result not have the revenue streams coming from new products and services that it has historically.
MURRAY: I agree with much of what has been said here. I think the environment remains conducive to bank stocks' continuing to perform well. The three fundamentals that have been driving the sector-a relatively stable economic environment, continued consolidation and continued excess- capital generation-will continue to propel the sector. Those fundamentals are in place and will stay in place.
The revenue/expense situation is an issue. I agree that revenues are slowing, and expense and the need to spend and invest continues to mount. This phenomenon will continue to drive consolidation, which will be positive for the sector.
On the expense side, in particular, I think banks have a (problem) in that the cost structure, especially on the retail side of the business, is still too heavy compared to the nonbank competitors'. That pressure is not going away, so banks need to be creative about how to address the expense side, especially in the retail business, while trying to invest for growth.
How long has this underspending and underinvesting problem been going on?
COHN: It certainly has been going on for at least the last three years. The industry came out of the last recession with clearly excessive expense ratios, so those first couple of years of cuts certainly were not the issue.
The industry has gotten really good earnings gains by holding the rate of expense growth below revenue growth, but lots of small investments which would have led to future revenue streams didn't get made.
Managements have become less willing to take a chance, making it more difficult for the industry to find new products and services.
This is an industry that commoditizes its products really fast, so you've constantly got to be coming up with new products, new services, new offerings-or else your returns are going to go down,
Should banks purchase securities firms or grow the business internally?
MURRAY: I am somewhat troubled by these large banks' buying platforms that in my view will not be adequate over time.
I understand the pressure the banks feel from the companies that are able to access capital markets, and thereby do not need banks' balance sheets as much as they once did. Banks see this as incremental revenue pressure, and it is a legitimate concern.
But I would rather see them take their time and wait for a better opportunity-either when they are better prepared to buy big or better able, at least, to buy cheaper. I would rather see them wait.
My guess is that Chase, while I know they would very much like to have a more-developed capital markets program, will wait. Because, given their emphasis on scale, and how expensive that is likely to be in the securities business, they will wait and take advantage of some market development that will allow them to buy or build more cheaply than they can today.
Small banks are going after subprime customers of mortgage and auto- finance companies to build market share. Could there be credit-quality issues down the road?
COHN: The whole industry has got that issue. The problems thus far have been outside the banking industry-or if there have been problems inside the banking industry, they have been sufficiently small that we haven't really been able to isolate them and identify them.
On the one hand, there is no question that everyone in the banking industry is focusing on trying to get gross yields up.
Subprime lending is a hot topic in the industry, but I don't think the banks that I follow are likely to get in real trouble in those areas. Frankly, they are substantially more conservative than the independents. It could put some marginal pressure on, but in the absence of recession I don't think it is going to be a real issue for this industry.
STIEVEN: I would agree. Fortunately, most of the banks out here have not really have ventured into it, or the ones that have ventured into subprime lending are doing it on a relatively small basis. So, even if their small base blows up, they could almost get out with very little embarrassment.
The one positive about doing subprime business for these banks has nothing to do with the loans, but it has everything to do with the funding. The banks could be relatively good at subprime lending because they have a good funding base in general.
Banks have to realize, though, it is a totally different business from banking, and they need to have people who are not bankers running it. There is a huge culture gap between traditional banking and the subprime business.
CHUNG: I agree with what Joe and Larry have expressed so far. I think that the banks tend to be much more conservative.
A perfect example is NationsBank's indirect auto business. For the last three years it hasn't grown, because they didn't like the spreads on the business.
And why? Because you have companies like Jayhawk (Acceptance Corp.) and other auto subprime auto lenders who have been very aggressive about going out to the sector. NationsBank is not going to participate when spreads are this tight.
The one thing that I'm a little bit concerned about at this point is Washington Mutual buying Great Western, which has a pretty large consumer finance franchise. I do think that they are very conservative compared to companies like Household International or Associates, but it is something that I would like to watch a little more carefully.
MURRAY: I do think there is precedent in the industry for entering these businesses, improving operating returns, and creating shareholder value.
Barnett is a very good example. It has entered a number of these businesses. It has good people, and they have bought companies with very good track records, which has worked out very well from the point of view of profitability and stock performance.
CHUNG: What does Barnett do, just home equity?
MURRAY: They've got home equity, consumer finance, indirect auto, and now increasingly, with Oxford, more auto lease financing.
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The market as a whole is at very high level now and going toward 8,000. Is there some kind of correction in store, and if so, do the banks fall with the rest of market or become even more attractive?
COHN: We are relatively positive on the market. There is no question that the market is high by any historic standard.
On the other hand, the one thing that has to really impress anybody is the absence of inflationary pressures. We are increasingly of the opinion that the market worries about inflation are like generals fighting the last war. That war is over.
Banks have historically been defensive vehicles. That has clearly not been the way they have acted in the last four or five months. In market downdrafts, banks have gone down substantially more than the overall market.
I do think that what is going to be most important for banks is earnings momentum relative to the market. That will be the driving force. Buybacks are already in place, low inflation is largely there, so companies that can maintain good earnings momentum and good top line growth are going to be O.K.
We may start to see a splintering in the performance of the industry. Small-cap banks have done much better than big-cap banks this year. It looks to us like that is going to continue.
STIEVEN: The smaller banks are outperforming the larger banks partly because they have lagged for the last year. Those stocks are playing a little catch-up right now.
MURRAY: A couple of observations.
One of the reasons banks have underperformed recently in downdrafts is because most of the recent downdrafts have been interest rate related. Banks, being interest rate sensitive, would naturally underperform during those periods. If we were to have some kind of pullback in the market that was unrelated to interest rates, the banks might behave differently.
I agree that relative earnings growth is going to make a difference, but that is one of the reasons the banks are going to continue to do well. I think the 11% to 12% earnings-per-share growth that we are looking for for the sector this year is going to be achieved.
As long as that is the case, a lot of things-like the banks' slowing revenue growth and slowing earnings momentum-are going to be overlooked. My guess is the banks will continue to be very solid performers.
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Is all the spending on technology going to add up to revenue growth? Is data mining going to increase the bottom line?
CHUNG: Ten percent of industry expenses are going to technology. That's almost $2 billion for Chase alone.
In terms of trying to generate incremental revenue from technology spending, I am not sure that we are anywhere close to that yet. Maybe it will lower operating expenses or lower your credit costs, because you picked better-credit-profile customers, but I'm not so sure about revenue.
COHN: This whole thing strikes me as sort of a search for the Holy Grail. Banks are desperately hoping that they can find some sort of magical solution that is going to let them identify who the good customer is that is going to pay them back and wants what they are selling. If it were that easy, it would have been done by now.
Data mining may be another example of dis-efficiencies of scale in the banking industry. Big banks throw off so much information that they are having a tremendously difficult time utilizing it, and smaller banks seem to be able to handle it a little bit better.
Home banking is another one of these 'what are we trying to do?' situations. Home banking is just a way of displacing costs.
Instead of customers calling up and asking somebody in the bank to look up their balance, they look it up for themselves. The trick is to get people to do it and to want to do it. It is not clear that they will succeed unless the industry can raise prices on traditional services to a point where they can force people to use alternative delivery systems.
STIEVEN: Typically, leading-edge technology in the banking industry becomes bleeding-edge. Although somebody might develop something that appears great, it can wind up being copied or emulated by other providers, and you end up spending a lot of money for something that other people can get very quickly.
MURRAY: I'm surprised to hear Larry make such a broad statement about First Union. They are not leading with technology applied to a certain product, but rather technology that has resulted in a low-cost, effective operating paradigm.
COHN: You're absolutely right, but what you really see in First Union is not an issue of having invested in technology in terms of looking for a magical solution, but rather simply strong, smart management who understood how to take advantage of what . . .
MURRAY: . . . technology could do.
