With banking profitability seemingly set to retreat from peak levels, general trading values appear headed for a holding pattern. But diverging performances still will provide select investment opportunities. That's the consensus among the four experts participating in the American Banker's second-quarter analysts' roundtable discussion. At the same time, sharp differences between the panelists emerged over the time horizon for a profit downturn, the potential depth of eventual credit quality problems, and which performance indexes are most critical. For the launch of this quarterly feature, we invited four well-known bank analysts: Robert Albertson of Goldman, Sachs & Co.; Thomas Brown of Donaldson, Lufkin & Jenrette; Felice Gelman of Keefe Managers Inc.; and Dennis Shea of Morgan Stanley & Co. This panel will remain intact for a few more sessions. A rotation will begin thereafter, with at least one new voice joining the four-member group each quarter. In a wide-ranging discussion held at this newspaper's headquarters, panelists agreed that banking fundamentals remain solid and that most market concerns - over issues such as the direction of interest rates and credit quality - are already factored into trading values. That combination provides a floor for stock valuations. At the same time, several of the analysts cautioned that profitability declines are in the offing. As we traverse the next leg of the economic expansion, the mettle of better-managed institutions will stand out more clearly - as will the shortcomings of weaker rivals.
AMERICAN BANKER: Bank stocks took a beating last year as rates rose sharply. Rate concerns have eased this year, however, and the banking sector has rallied. As of June 12, the American Banker index of 225 bank stocks was up 17.8% from the end of 1994.
Still, there are many concerns, ranging from the sustainability of revenue growth to credit quality. Do bank stocks still have room to run? Where do you stand on the sector, and what are your top picks?
ROBERT ALBERTSON: We are in our fourth year with our first-priority stock being Citicorp. The bank has a franchise unequaled anywhere in the world, and the stock is selling at an outrageously low multiple.
After Citicorp, however, I think it is time to reduce weightings and become more selective. While the industry is only partly through its loan cycle, we are far enough through that we've got to watch for the disciplined pricers, the disciplined underwriters, and most importantly, the most creative marketers.
I still sleep pretty easily because price-earnings ratios are very low and the support provided by stock buybacks is going to help for quite some time.
Our favorites tend to be in the West right now, because we think that region's loan cycle is comparatively younger. First Interstate Bancorp is high on the list; BankAmerica Corp. is high on the list.
Beyond that, we still like cost cutters that haven't finished cutting, such as Chemical Banking Corp., Chase Manhattan Corp., and CoreStates Financial Corp. Among the marketers, our favorites are Banc One Corp., NationsBank Corp., and Norwest Corp.
DENNIS SHEA: The stocks I've been recommending strongly this year include Mellon Bank Corp. - and as I've often said, I've got the bruises to prove it. BayBanks Inc. has done quite well as an organization. But as a stock, I think, it is poorly understood. And Bank of New York Co. is third. I haven't recommended and won't recommend stocks strictly on takeover possibilities.
In terms of the group, I, like Robert, become less comfortable with it as a whole. For some odd reason, stocks tend to perform much better in the first half of the year than in the second half. So we probably all ought to declare victory on June 30 and go home.
But my overriding concern about the group is that we've hit a peak cyclical return on equity. I think it is going to trend down. It is just a question of how far and how fast. And that is what I spend most of my time trying to determine.
FELICE GELMAN: First of all, there are some revenue stories. For as far along as we are in the cycle, there are banks that have figured out how to grow revenues.
The three that come to my mind right away are Citicorp, Bank of Boston Corp., and Signet Banking Corp. Citicorp's global consumer franchise is really exciting. Bank of Boston has great growth opportunities in Latin America and in the consumer finance business. At Signet, the story is pretty well known, but I think the results are going to be stellar.
Another theme that hasn't gotten attention is what I would call the consolidators. There are some banks that are just terrific at making acquisitions or at reconfiguring franchises such that existing properties are sold at high multiples and new properties are acquired at lower multiples. Probably one of the best examples is Bank of New York. Then there is H.F. Ahmanson & Co.
And then, finally, takeover candidates. We've got a long list. Rather than name them, I would just say that I think there's going to be a tremendous amount of takeover activity. If I were to point to the market that will be the hottest, I still think the Southeast, though a lot of the deals will involve names that are not that well known.
THOMAS BROWN: I think we are in a tug of war, that being the declining profitability that we are seeing. There are going to be more disappointing earnings. Our estimates today are too high for 1996. On the other hand, as Robert mentioned, the valuation levels of the group suggest everybody knows all of that. Pretty clearly, that's already reflected in pricing.
So I think we go through periods, as Dennis suggested. The first half of 1995 is outperformance, the second half is underperformance, and we start up another cycle, maybe in late 1995 or early 1996. But the group average will trade right around the market. So don't own the group. Own individual companies.
My companies fall into two categories. One story is about commercial banks that are becoming information banks. And the other - hopefully going hand in hand - is about productive uses of capital.
Capital One Financial, the credit card operation, would be my top pick in the group. My other picks include Signet Banking Corp and BankAmerica. And the best-managed company in the industry continues to be Wells Fargo.
Other names at the top of my list are Bank of Boston and Northern Trust. I would be remiss if I didn't mention Citicorp. The list out of 65 companies is not that broad.
AB: Where do margins fit in the pictures you've painted?
ALBERTSON: I think the margin behavior last year proves most banks know what they are doing. The average bank margin was dead flat the entire year in the face of a doubling of interest rates - a total surprise - and a sick bond market. Of course, we had a few exceptions. But I don't think the margin issue is as big as investors make it out to be.
BROWN: I would disagree. Your point was good, in that the average margin was flat. But look at the extremes. One theme I am going to talk about today is the widening range of performance.
SHEA: Last year, loan growth was not aggressive. The banks didn't start saying, "Yes, we have to bring in core retail deposits," as opposed to just funding themselves by drawing down securities portfolios and money market portfolios.
We are starting to see significant loan growth. So I think that is going to be a test. I agree with Tom. I think the margin is a huge issue going forward. I am not that comfortable that we are seeing a pattern that is sustainable.
ALBERTSON: Well, I certainly agree there is a widening divergence in banks, and we've got to really narrow down investment choices. I don't think margin is the big issue, though.
I think the issue is marketing sophistication. And, secondarily, productivity. I think third, it is loan pricing. I don't care what happens to deposits as long as everyone pays attention to how they rent the money out.
GELMAN: It has become increasingly difficult, in fact, to measure performance by looking at the net interest margin.
Financial technology has allowed banks to securitize assets all over the place. So the earnings power and market share of banks is probably a lot bigger than it looks. It is difficult to tell, really, what a bank's true lending margin is, because so much doesn't appear in the yield calculations.
A further consequence of securitization is that less pressure is placed on deposit rates. True, deposit rates have moved up. But compared with where they have been historically at this juncture of the economic cycle, they've really lagged. And I don't think there is any reason they shouldn't continue to lag.
As to Tom's point about divergence: If you originate stuff that can't be securitized, or is of low quality or too aggressive on price, and you are stuck with that on the balance sheet, then you really lose flexibility and an ability to perform. But financially well-managed banks have tremendous flexibility.
AB: What about credit quality? When will loss provisions start climbing, and how steep will be the ascent?
ALBERTSON: The most common question I get from clients is about credit quality, ironically, when there is absolutely no leverage in the corporate sector. There ain't no recession in sight, and loan-loss reserves are still gigantic.
We are far off from a serious loss cycle. We will get there for sure. It is just sad to see investors already discounting for it.
SHEA: But the next credit cycle is going to be nothing like the last one. No way you can compare. I haven't seen a time when the industry has been better prepared to deal with that.
ALBERTSON: I agree, but investors don't seem very comfy.
BROWN: Earnings can be held flat for a couple of years at some of the banks I cover, only because their provisions are going from unsustainably low levels back to normal levels.
GELMAN: But if you look at the level of reserves right now, and how much loan growth it would take to lower reserve ratios below conservative levels, we've got room for plenty of growth. Barring a collapse of the magnitude we saw last time in real estate, bank reserves are more than adequate to support quite a lot of loan growth for quite a period of time.
BROWN: I don't believe the industry's reserves will ever go below 1.5% of loans again. My basis for operation is that we now have a new, higher floor. And that higher floor is not reflected in loan pricing.
SHEA: But chargeoffs will be much lower in the next cycle, because banks look more like thrifts. They've got these big home mortgage portfolios that won't show a big loss content.
BROWN: Still, banks have done a poor job of pricing loan products for the different risks. I can see some companies taking more risk, accepting higher chargeoffs - but pricing for it.
ALBERTSON: There are banks doing what you want. They are building consumer finance units that go down-market, take higher risks, but professionally, with experienced managers.
GELMAN: But if we think reasonably capitalized banks should have equity- to-assets ratios of between 6.5% and 7%, and then we are saying on top of that, they should have reserves equaling 1.5% to 2% of loans, then we are saying something about the kinds of returns that ought to come out of the business. And what we are saying is that returns on equity ought to be lower than they are.
I am saying banks have lots and lots of room to buy back stock, reduce their equity, and reduce their reserves, and that they will do that in order to maintain their returns.
BROWN: I might agree with you. But I would like to see the regulators sit by, while chargeoffs and nonperformers are rising, and see the industry continue to lower its equity ratio and take its reserves down. I don't think it is going to happen.
AB: Let's talk about mergers and acquisitions. What types of transactions will we be seeing over the next year? What will be some of the drivers?
ALBERTSON: I believe the first theme you will see is a lot more regional grooming. You need to be pretty significant in a region, market-share-wise, and maybe broader than you are now, in order to fit, longer term, somewhere else. The Shawmut sale illustrates that, because New England is still a region with very small market shares.
We've got to finish the regionalization that started years ago in the Southeast and West. Four and five percent shares aren't going to do it, and one large share in one single state may not do it either.
AB: But there's a conflict. On the one hand, acquirers themselves might become more salable by building regional franchises. But then if you look at the terms of these deals, for acquiring shareholders in the short term ...
SHEA: The numbers don't work.
AB: They don't. So do you see a continuation of that, to where, for the sake of the greater long-term good of building attractive regional franchises, there are going to be some pretty painful transitions for shareholders of acquiring institutions?
GELMAN: I don't think pricing has to be the obstacle. A lot has to do with execution.
First Bank System is a great example of a company that has done a number of acquisitions. Every deal they've done has been a good deal. At Bank of New York, every deal has been accretive.
AB: But are we going to continue to see deals falling short of those standards?
SHEA: Of course. You've got a lot of banks out there that have hit a wall on earnings, and hit a wall on revenues. They've got no other place to go. And there are others out there that are either desperate or that believe it makes economic sense to move into certain regions. And you are going to see more deals.
GELMAN: Plus, the acquirers are getting more currency to work with. I don't know if you've noticed it, but the trading multiples of the S&P 500 banks have pretty much broken away from the smaller-cap banks. That is the environment for mergers and acquisitions.
BROWN: Small banks may trade at discounts to big banks, but the ones we all view as the likely targets are trading at premiums to the big banks.
ALBERTSON: And you have a seeming contradiction: The smaller the target, the harder it is going to be to take costs out of that bank, to make the deal accretive. So I think deals are going to gravitate, frankly, to larger institutions.
AB: Will we see acquisition premiums return to prior levels?
BROWN: I will say it. I think acquisition pricing peaked last year.
ALBERTSON: I agree. I think we are on our way down.
SHEA: If you are considering selling, and you haven't done it yet, do it now.
BROWN: And if you haven't done it a year from now, do it then.
SHEA: A lot of banks are kidding themselves. I think we are talking about peak earnings for the industry. We've got provisions that are half, if not less, of the normalized rate. We've got margins that I believe will come down. Maybe not drastically, but down. So when I study the industry and try to come up with what is normalized, I come up with 200 basis points less in return on equity than what we have right now.
ALBERTSON: So you'll go down to what?
SHEA: Roughly 15%. The problem is that you have bankers out there saying, I am earning a 17% return on equity, and I want a big multiple off this peak. What they should be doing is pegging a sales multiple off a lower, more sustainable return.
AB: A priority everybody brought up prior to this meeting was technology, conjoined with marketing, conjoined with efficiency. How well is that going? Are we seeing broad-based industry progress or are we seeing a few notable examples and a large field of laggards?
SHEA: We are looking for companies that are giving employees sales tools and the ability to make a difference. And maybe the $80 million customer profitability system is just too good - overly sophisticated for the sales force.
GELMAN: I don't think banks have good information. I haven't found anybody making serious use of the data bases culled from, for example, mortgage banking. And part of the reason is the data has never been collected in a form that can be used and analyzed.
BROWN: This highlights the difficulties of making the transition from a commercial bank to an information bank.
AB: What are the implications for competitiveness? Are non-depository institutions in fact are doing a markedly better job of managing information and marketing? Can banks close the gap?
BROWN: So far, banks have been getting killed by the category killers, the one-product operations. There's no reason that banks can't dominate relationships. But they've got to manage the relationship. And right now, they don't have the information available to manage the relationship.
GELMAN: Plus, it is a question of focus. You know from opening your mail how focused the credit card companies are. If you are like me, you've gotten maybe 150 card solicitations this year that you didn't even open. Why are you still getting them? It is not that the card units are saying you are the most likely person to respond, they are just targeting you.
ALBERTSON: They just want to sell a credit card. They are not after the entire relationship.
If banks are to survive and prosper, they have got to amplify the relationship. The question now is: Can you take a bank branch, and the nonbranch delivery system growing around it, and turn it into something valuable in a relationship?
AB: It is almost as if your arguments are going against financial conglomerates. What many of you seem to be acknowledging is that yes, in fact, the category killers got there for a reason - because they do have a focus.
Are we at the point of saying maybe some huge financial conglomerates aren't doing the best job for shareholders? And even if you do believe that, can any meaningful pressure be brought to bear on managements?
BROWN: You are going to have winners among the category killers, and winners such as Citicorp, which can dominate relationships. The people who don't have a strategy, who are caught in the middle, will be the ones who continue to lose share.
ALBERTSON: We also tend to forget that recent category-killer winners recently are in categories that may have some severe cyclical limitations. Mortgage banking has not been a bed of roses over the last year. The card, I think, is too much maligned. But ultimately, I think it is running up against a profitability wall. Now, what happens to them when they have about as much as they are going to get in terms of customer share, and within that pool they want something more? They are going to be more cyclical than banks unless they can broaden the relationship as well.
BROWN: The other issue you raised is: Could we see some pressure? And I think that Robert's point is well taken about the cyclicality of individual lines of business.
But, for the foreseeable future, when a business line is hot, it will trade at a very high multiple. The gap between where the conglomerates and the pure plays are trading has never been as wide. And there certainly are more publicly traded category killers than ever before.
I personally believe that Michael Price's pursuit of Chase is a seminal event in the industry, and that one way or the other, we are going to see a closing of the gap between some of these underperforming conglomerates and the pure plays.
SHEA: That is providing some nice valuation floors for some of the underperformers. There are some stocks out there that, despite bad news, don't go down, because of the value of all the underlying pieces.
BROWN: Despite what could be a multiyear period of terrible performance.
SHEA: Right. The earnings really aren't what's driving some of these stocks. It is a nice situation when you can find it, when you have a valuation floor on a stock and some upside. First Chicago is one, and I think Mellon is one.
GELMAN: But the floors will be weakened by the cyclicality of those businesses.
SHEA: But there are a number of businesses.
GELMAN: But the support will be limited. Take Chase, for example. Look at the businesses people have focused on: the card, the indirect auto, mortgage banking, and trust. None of those run particularly counter to a cycle. And when we go into a recession, I don't think they are going provide a floor at all.
SHEA: Well, but as long as the stock trades at a big enough discount to the inherent value of those different businesses ...
GELMAN: No, but I am saying the value of those businesses is not necessarily going to be sustained at the same level. And really what I am saying is, there are managements out there that either see acquisition premiums in their stock or see breakup floors in their stock. If they don't get themselves off the dime and turn that into real value, they are going to be in trouble in the next recession.
ALBERTSON: They have to prove the relationship paradigm works, and works well, and that they can do the cross-selling.