By Philip van Doorn
Big banks still face challenges. Analysts at KBW favor those with 'inexpensive balance sheets' that can benefit from two industry trends.
Bank stocks have lagged behind the broad market for most of 2023, and the failure of three large institutions early in the year may have left a sour taste in investors' mouths. But some bank stocks are attractively priced right now, and targeted investments in the sector may turn out to be lucrative in 2024.
In a report on Dec. 6, analysts at Keefe, Bruyette & Woods wrote that they were confident that the worst of downward earnings-estimate revisions was behind the industry. Investors typically want to see a steady increase in earnings estimates to support stock prices. But the reverse was taking place as many banks faced declining net interest margins - the spread between the interest rates they earn on loans and securities investments and what they pay for deposits or borrowings - as the Federal Reserve increased the short-term federal-funds rate and pushed long-term interest rates higher by reducing its bond portfolio.
For 2024, the KBW analysts recommend that investors hold stocks of banks with "inexpensive balance sheets," as well as those banks expecting to increase their tangible book values significantly and banks with capital-markets businesses that are "poised for a rebound."
Setting the stage
Last week's decision by the Federal Open Market Committee to hold firm on interest rates and the indication in the Fed's economic projections that the federal-funds rate would be cut three times in 2024 reinforced the expectation that better times are ahead for banks.
Here's a roundup of rate-cut predictions from 12 economists.
Here's a chart showing the performance of the KBW Nasdaq Bank Index BKX against that of the S&P 500 SPX this year through Friday, both with dividends reinvested:
You can see the plunge in early March for the KBW Nasdaq Bank Index and an upswing starting at the end of October and continuing this month. The March action was focused on the failures of Silicon Valley Bank of Santa Clara, Calif., on March 10 and Signature Bank of New York on March 12. Then the troubled First Republic Bank of San Francisco was closed by regulators on May 1.
The rapid rise in interest rates resulting from the Federal Reserve's change in policy early in 2022 took its toll as banks' deposit costs rose. The three failed institutions had specific problems:
Silicon Valley Bank was focused for decades on lending to and gathering deposits from venture-capital firms. The bank faced a perfect storm of deposit outflow because the VC companies' own sources of cash dried up. The bank was forced to raise cash by selling securities at a loss after bond prices had been pushed down as interest rates rose.Signature Bank of New York had a diverse business model, but its increasing focus on providing services to virtual-currency exchanges and related companies led to a damaged reputation and enough deposit outflow for state regulators to decide to close the bank.First Republic Bank was focused on serving high-net-worth clients, which included making jumbo mortgage loans, which were too large to be purchased by Fannie Mae or Freddie Mac. This meant the bank was saddled with a large portfolio of loans with low interest rates, while costs for deposits were ballooning. That problem, along with paper losses on its securities portfolio, helped lead to a loss of confidence, a run on deposits and eventually a decision by state regulators to close the bank.
That bit of history may stop weighing on bank stocks, not only because of the expectation that costs for deposits will come down next year, but because of the way the stock market has been reacting to the Fed and to economic developments. The yield on 10-year U.S. Treasury notes BX:TMUBMUSD10Y has fallen to 3.91% from 4.88% at the end of October. As interest rates fall, bonds' market valuations increase. This eases pressure on banks and can boost their earnings as well as their regulatory capital ratios.
Top picks among large-cap bank stocks
David Konrad, managing director of equity research at KBW, favors three large banks, which he discussed during an interview with MarketWatch.
KeyCorp
Shares of KeyCorp (KEY) of Cleveland are down 18% this year, excluding dividends. But the share price has risen 37% over the past two months to close at $14.32 Friday.
KeyCorp pays a quarterly dividend of 20.5 cents a share. That annual dividend payout of 82 cents makes for a dividend yield of 5.73%, based on Friday's closing share price.
Konrad said that the bank has been "earning little on its balance sheet" and that its payout ratio (dividends to earnings per share) has been running at 80%. For the third quarter, the bank's net income available to common shareholders was 29 cents a share, down from 55 cents a year earlier. The bank reported a tax-adjusted net interest margin of 2.01% in the third quarter, narrowing from 2.74% a year earlier.
According to Konrad, "almost 30% of their balance sheet is earning 30 basis points and will reprice by the end of 2024." KeyCorp had loaded up on 2-year Treasury notes before the Fed began raising interest rates and before deposit costs shot up. With so much of those securities and $30 billion in "underwater" interest-rate swaps maturing next year, Konrad expects KeyCorp's earnings to rise meaningfully. He said "the payout ratio will probably be cut in half."
He sees a good "risk-reward" relationship for the stock "as you get through the first quarter. Then capital risk subsides meaningfully as earnings increase."
Konrad estimates KeyCorp will earn $1.82 a share in 2024, which is ahead of the consensus earnings-per-share estimate of $1.29 among 23 analysts polled by FactSet. His price target for the stock is $15, which is only 5% ahead of the stock's closing price of $14.32 on Friday. The stock rose 8% last week.
Odeon Capital analyst Richard Bove also rates KeyCorp a buy, but with a higher 12-month price target of $15.45. In a note to clients on Thursday, Bove wrote: "It appears that KeyCorp will be making major operating adjustments in the fourth quarter. This is likely to reduce earnings so that quarterly results may be disappointing."
He expects heavy action by the bank to reduce its exposure to loans considered to be higher-risk under new regulatory capital requirements. He also expects "high severance and automation costs" through 2024 as the bank reduces expenses, in part by laying off employees.
Those moves, an improved interest-rate environment and "greater opportunities" in capital markets as companies "restructure their balance sheets," all should help KeyCorp's earnings to "pop higher in 2025," following moderate earnings growth in 2024, Bove wrote.
Truist
Truist Financial Corp. (TFC) of Charlotte, N.C., was formed when BB&T Corp. merged with SunTrust of Atlanta in December 2019. The stock has fallen 17% this year, but it rose 29% from two months earlier to close at $36.70 on Friday. Truist pays a quarterly dividend of 52 cents share for a yield of 5.67% at Friday's close.
"Truist is in the camp of a few banks that added duration at the wrong time, which created market-to-market capital concerns [as the value of securities investments declined] and a really low net interest margin," Konrad said. The bank reported a third-quarter net interest margin of 2.95%, narrowing from 3.12% a year earlier. Its third-quarter EPS to common shareholders came in at $1.07, down from $1.54 in the third quarter of 2022.
Earlier this year, Truist sold 20% of its insurance-brokerage business to Stone Point, a private-equity firm. According to a Semafor report in October, the two companies were negotiating the sale of the remaining 80% for about $10 billion.
The completion of that deal would not only increase Truist's regulatory capital ratios by about 300 basis points, it would improve its 2024 EPS to an estimated $4.40 from $3.70, Konrad said.
"So this can be viewed as short-term," he said, "but it also puts Truist in a position where they can grow."
Konrad has a $36 price target for Truist, which is now below the bank's closing share price of $36.70 on Friday. But Bove upgraded Truist to a buy rating Monday morning, with a price target of $40.45.
Goldman Sachs
"Overall, we are still very positive on capital markets next year," Konrad said. He cited "anemic levels for seven or eight quarters" for the investment-banking industry. "There is only so much time people can wait before doing transactions, capital debt or strategically," he added.
Shares of Goldman Sachs Group Inc. (GS) closed at $380.51 on Friday, up 11% for 2023. The bank pays a quarterly dividend of $2.75 a share, for a yield of 2.89%.
According to FactSet, Goldman Sachs trades for 1.1 times its tangible book value per share. That is below FactSet's P/TBV ratios of 1.3 for KeyCorp and 1.5 for Truist. But it may be of more interest that shares of Goldman archrival Morgan Stanley (MS) trade for 2 times tangible book value, according to FactSet.
Konrad sees "less downside risk" for Goldman because of its low valuation to book. He also believes a decline in interest rates will support capital-markets activity. Finally, he cited Goldman as a "restructuring story," not only from its exit of its consumer-lending business, but from a reduction in the size of its balance sheet, to boost regulatory capital ratios.
Konrad's price target for Goldman is $400.
-Philip van Doorn
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12-18-23 1052ET
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