Three Reasons Why the Big Banks Will Continue Thriving

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The banking sector has been on fire during 2012, with shares of bellwether Bank of America (NYSE: BAC) almost doubling during the year. The sector could be up for a pullback after such a great year, especially if the coming earnings season generates some uncertainty from investors in the sector. On a longer timeframe, however, big banks will continue thriving.

Improving Macro Fundamentals

The chart from the Federal Reserve Bank of St Louis shows a very interesting picture, household debt payments as a percentage of disposable income are reaching record lows. This means that the deleveraging process by consumers has been painful but effective, and American families are in much better financial shape than in recent years.

<img src="/media/images/user_1532/debt_large.png" />

2012 was also the year in which real estate activity bottomed and started rising, and that's a big driver for the financial sector. Real estate moves in long term cycles, so both prices and both construction activity have plenty of upside room from current levels.

The Fed is throwing tons of money at mortgage related assets; this helps bank's balance sheets and reduces interest rates in the mortgage market. Houses have not been so affordable for a long time, and prices are already moving up, so things are looking good from that point of view.

The automotive industry is another positive factor to keep in mind. US car sales are approaching their 2007 highs, and they still have a lot of room to run as the average age of US cars on the road is close to 12 years, way above the average of 7 years of age which has been observed over time.  Car loans should be another tailwind for the banking sector in the middle term.

Improving Balance Sheets

While the healthier banks like Wells Fargo (NYSE: WFC) and JPMorgan (NYSE: JPM) have been increasing their lending activity and gaining market share versus their “not so healthy peers” Bank of America and Citigroup (NYSE: C), they all have come a long way in cleaning their balance sheets. The recent settlement that Bank of America announced with Fannie Mae is an important step in that direction, and it’s not an isolated event. Improvements in balance sheet quality have been slow but steady over the last years.

The evolution of return on equity ratios for these banks shows some differences: Wells Fargo and JPMorgan are quite profitable, while Bank of America and Citigroup are still struggling to deliver positive results. But the trend is quite clear, the “big four” are moving in the right direction when it comes to profitability.

<img src="/media/images/user_1532/roe_2_large.png" />

Attractive Valuations

In spite of a steep rise in 2012, the big US banks are still trading at attractive valuations from a long term point of view. The price to book value ratio is a traditional method for valuing financials, and it shows that there is still a lot of upside potential in the sector from a historical perspective. 

<img src="/media/images/user_1532/valuation_001_large.png" />

Rising dividends could be a big catalyst in the middle term. As the banks get in a better financial shape and recover their lost profitability, it’s only logical to expect bigger dividend payments from them. This would not only be important from a total return perspective, it would also have big implications in terms of investor’s sentiment towards the sector. Growing dividends would indicate that the worst is behind the big US banks in terms of balance sheet quality, and that they are now ready to focus on growth opportunities.

Bottom Line

Big US banks had a wild ride last year, but this move was not disconnected from their fundamentals. On the contrary, things are looking better for the sector, both from a macro economic and company specific point of view. Valuations are still historically attractive, so the banks are well positioned to deliver juicy returns over the next years.

Regarding specific names, Wells Fargo and JP Morgan are in better shape, and could be considered the high quality bets in the sector. Bank of America and Citigroup are much cheaper, so they have more upside potential, but they also carry more risks and uncertainties since they are not completely out of the woods yet.

 


acardenal has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo & Company. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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