U.S. bank stocks have lots of room to run

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Banks in the United States are back from the brink, and their stock prices are back with them. The sector as a whole is up by about a third since the beginning of 2012.

So you've missed out on your chance to make money? Not at all.

Even after their remarkable run, U.S. bank stocks remain priced below their long-term averages – by anywhere from 25 per cent to nearly 60 per cent, according to bank-specialist firm Keefe Bruyette & Woods Inc.

In part, the discount recognizes that slow economic growth and stubbornly low interest rates, plus increased regulation and capital requirements, have clipped banks' earning power.

But even with those headwinds, aggregate profits for publicly traded U.S. banks are still only around the peak levels of 2006, notes Robert Wessel of Toronto's Hamilton Capital, which runs funds that invest in U.S. bank stocks. Back then, bank profits stood at around $100-billion (U.S.); the new normal level of earnings with an improved economy and higher rates, he suggests, is $120-billion.

A recovery to that level – which, to be fair, may be more than a year in the making – would send share prices even higher.

"If the economy picks up, with loan growth accelerating, and interest rates start rising again, the banks are cheap relative to what would be more normalized earnings," agrees Lana Chan, an analyst who covers banks for BMO Nesbitt Burns' U.S. arm.

In another positive development, U.S. banks will undergo a second round of "stress tests" by the Federal Reserve later this year. Those that pass will be allowed to increase their dividends and share buybacks, potentially bringing yield-hungry shareholders back to the table.

Will all boats rise with this tide? Probably – but some may rise more than other. So while a Canadian investor can get exposure to the whole sector through any number of ETFs, it may be best to pick and choose. Globe Investor crunched the numbers and talked to a number of equity analysts to highlight some of the most compelling names in the sector.

To start, we took a look at the S&P Banks Select Industry Index, which contains 40 of the U.S.'s biggest banks. To winnow the list, we searched for banks that were of average or above-average profitability on at least one of two key metrics: return on assets or return on equity. Then, we probed to see if they were average or cheaper than average on at least one of two valuation yardsticks: price-to-tangible book value or forward price-to-earnings ratio. Only 15 banks met the test (see chart).

Three financial institutions – Fifth Third Bancorp, SunTrust Banks Inc. and Huntington Bancshares Inc. – dominated the categories. And they were among the names most often mentioned by analysts.

The curiously named Fifth Third, out of Cincinnati, is "one of the nation's great franchises" that got off track in recent years with a few too many acquisitions, says Thomas Mitchell of Miller Tabak & Co. Inc. Mr. Mitchell, who likes banks that look attractive to potential acquirers, but are also big and healthy enough to do acquisitions on their own, says that recent share prices around $16.50 are a "significant discount" to its takeover value in the mid $20s.

Other analysts like Fifth Third even without the acquisition angle. Ms. Chan says her colleagues on the BMO analyst team favour Fifth Third ($19 target price) for its potential to add loans in what seems to be a rebounding Midwestern economy. And Brian Klock of Keefe Bruette & Woods says that his analyst colleagues at the firm believe once Fifth Third's large position in public payment-processing company Vantiv Inc. is considered, the remaining banking franchise is trading for less than nine times earnings.

SunTrust, an Atlanta-based company that got hit hard in the Florida real estate downturn, actually flunked its first stress test and was unable to raise its dividend last year. Things will likely be different this year, says Ms. Chan, who notes that the bank's earnings stand to soar as housing prices recover. BMO's target price is $33 and RBC's is $30, versus recent trades around $29.

Huntington, a Columbus, Ohio, company, also meets Mr. Mitchell's test of acquire-or-be-acquired banking companies. It's "night and day" different from several years ago, when "it had no general direction" and made an ill-timed mega-deal at the market peak. Since then, Mr. Mitchell says, it has raised capital at low prices, disposed of troubled loans and bad assets, and has "built its franchise value."

Maclovio Piña, an analyst at Morningstar Inc., says Huntington has one of the largest discounts to its fair value among banks he covers, since it's trading about 10 per cent below his estimate of $8.

Analysts mentioned other names from our list that may have been a little less profitable, or a little more expensive, than others.

U.S. Bancorp, with its consistent profitability through the crisis, may be the most Canadian of the U.S. regionals. It's a recommendation at RBC Dominion Securities' U.S. arm and at Keefe Bruyette & Woods. Morningstar gives it a four-star rating and estimates its fair value at $37, above the current levels around $33.50.

Joe Morford of RBC likes Wells Fargo & Co., with an "outperform" rating and $40 target price, compared with recent trades below $36. He notes it's "a great play on the housing recovery" as the nation's largest originator and servicer of mortgages. Its diversified operating model helps it post revenue gains, he says, and its 1.5-per-cent return on assets and 13-per-cent return on equity make it the most profitable among the biggest of the big banks, a group that includes JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. (RBC also has "outperforms" on Bank of America ($14 target), Citigroup ($48) and JPMorgan ($52) because, Mr. Morford says, "we see more value among larger names trading at bigger discounts.")

And Mr. Klock likes M&T Bank Corp. of Buffalo, N.Y., another "conservative" bank that didn't lose money in the crisis, but has still demonstrated revenue growth and pays a dividend that yields 2.7 per cent. Wall Street doesn't fully appreciate the earnings benefits from its impending deal for Hudson City Bancorp, Mr. Klock says. His target price is $111, versus current prices around $104.

Our decidedly unscientific screen is not the be-all, end-all, however. Analysts named a couple of other banks they consider cheap.

BMO, RBC and Miller Tabak all like Regions Financial Corp., a Birmingham, Ala., company that was hit even harder than SunTrust by the Florida crash and, similarly, has earnings leverage to a housing rebound. "Their valuation is so low that we think anybody big enough to buy them with a normal cost of capital could go in and make more money out of that franchise than they can as an independent," Mr. Mitchell says. BMO and RBC have a $9 target price, compared with recent trades below $8.

RBC has an "outperform" and $36 target price on Comerica Inc., a bank formerly headquartered in Detroit that moved to Dallas several years ago to reflect its Sunbelt aspirations. Its Michigan legacy, combined with its California-Florida-Arizona expansion, have given it elevated levels of bad assets. Yet, says Mr. Piña of Morningstar, who has a $38 fair-value estimate, "the company has made good progress in digesting these bad loans … and should be able to comfortably pay its common dividend and maintain its share buybacks."

Special to The Globe and Mail

The author owns shares of Wells Fargo, Fifth Third Bancorp and PNC Financial Services in retirement accounts. Also, as a freelance writer, the author received $7,312 in compensation in 2012 for producing content for publications for Wells Fargo's customers.