Morgan Stanley Picks Banking's New Winners
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Analysts at Morgan Stanley (NYSE: MS) came out with a slew of big capitalization bank stock recommendations. “Overweight” ratings were issued for Citigroup (NYSE: C), and Regions Financial (NYSE: RF), among others. Among former Morgan Stanley favorites downgraded to equal weight were Wells Fargo (NYSE: WFC) and BB&T (NYSE: BBT). The obvious issue is that the two upgraded banks have been among the worst performing over the past five years, while the downgraded banks have been two of the strongest.
Citigroup had its target raised from $45 to $51 per share, representing a 28% gain from the big bank's price as I write this. The Morgan Stanley analyst reasoned that Citigroup's 6.9% return on equity was likely to rise from 6.9% in the third quarter of this year up to 7.6% for all of next year, and then up to 10% out to mid-decade. I am not a fan of bank analysis by way of returns on equity, because the denominator, or amount of shareholder equity, is a moving target. Due to regulatory requirements, all banks have vastly increased their equity levels, as that is a key component of capital regulations that have been passed. Citigroup's shareholder equity has grown from $113 billion in 2007 to about $187 billion at the close of the third quarter.
All things being equal, it makes far more sense to judge a bank's results by way of its return on assets. Of course, asset levels may grow or fall, but at least asset levels are related to profit potential, unlike equity levels. That does not mean I don't see upside in Citigroup. Citigroup is cutting costs, most recently by eliminating 50 data centers worldwide.
The big overhang on Citigroup now has to do with tax policy. Citigroup and General Electric (GE) derive substantial portions of their income from overseas. Tax changes may require them to pay billions of dollars in 2012 in taxes on dividend on interest income, aka, the active financing exceptions. Given the tenor in Washington toward debt reduction, this exception to earnings overseas will surely end.
Citigroup has pretty much missed the boom in mortgage real estate refinancings that have helped so many banks in recent quarters, and has instead focused on what it terms “emerging economies.” I look forward to its winter of 2013 stress test results, but am more interested in seeing Citigroup's worldwide presence pay off for it and its shareholders. Considering the 10:1 reverse stock split in 2011, Citigroup is a long way from its pre-recessionary valuation, and the ride back, if made, might just make a lot of people a lot of money. Hop on board if you can be patient and accept some risk.
Morgan Stanley upped its 52-week target on Regions Financial from $8.00 per share to $8.50 per share, which represents an upside of 20% from Regions' share price as I write this. This bank restructured and diluted shareholders with a new equity offering in order to pay its TARP loans in the second quarter of this year. The stock target was raised due to the same reasons I bought Regions stock about nine months ago. Its' loan portfolio has largely been purged of some of the large and risky commercial real estate loans that crippled the bank these past several years. That, and a focus on deposit taking and traditional mortgages, have returned Regions to profitability. Regions' improved credit rating will also help reduce its credit costs.
Regions is on track to earn about $1.2 billion, or $0.75 per share this year, which would give the bank a return on assets of 1.0%, a real milestone in the bank's recovery. As its geographic footprint of the Gulf Coast states picks up steam, and its loan portfolio grows, it is easy for me to envision Regions stock doubling in price out to mid-decade.
Most everyone's favorite bank stock, Wells Fargo, was downgraded due to the perception that it is now trading at fair value, and like many banks, has its net interest margin under pressure. Morgan Stanley's $39 target is a 10% premium to Wells Fargo stock price as I write this. It bears noting that many other analysts, such as Jefferies Group (JEF) still have buy ratings on the stock, and that Warren Buffett increased Berkshire Hathaway's (BRK) exposure to the big bank. Morgan Stanley also noted that unlike many of its peers, Wells Fargo has little to gain in terms of efficiency.
My main concern with Wells Fargo is that has had an utterly dominate position the past few years in the domestic mortgage loan market, in recent times having a market share of 33% or more. My concern about Wells Fargo is what could become of the bank if the mortgage market again implodes as it did last decade. Otherwise, while it contends like other banks with interest margin challenges, Wells Fargo figures to earn about $17.5 billion, or $3.35 per share this year, versus $2.82 per share last year. This is a “best of breed” big bank, one that deserves to be in most portfolios, regardless of what Morgan Stanley believes.
I have only avoided BB&T over the years because of the outwardly political nature of its management. But if you have been better able to stomach that than I am, you have invested in a winner. BB&T struggled in the recession, but never came close to losing money in any year due to quality underwriting in its loan portfolio. Morgan Stanley has a target price of $33 per share, which would be an advance of 12% from the stock price as I write this. The investment bank cites the declining interest margin, and increased expenses due to BB&T's build out of its Texas franchise. The Texas bank was part of BB&T's 2009 buyout of Colonial Bank in a government aided acquisition.
BB&T is on track to earn right about $2 billion this year, or $2.69 per share, which would represent an increase of 47% from 2011. Recent acquisition, particularly of BankAtlantic last summer, have aided the big increase. I see little reason to question BB&T continued expansion of its return on equity from its current 1.05% up to 1.20% or more by mid-decade. Add in its 2.7% yield and the likelihood of annual dividend increases, and I see BB&T as a strong banking bet for conservative minded investors.
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