The biggest, most global, most complex of the United States' banks were damaged goods coming out of the financial crisis. The long-term investment thesis, however, was that in time the wounds would heal, and they would unleash their massive earnings power to return to their place as some of the most valuable banking franchises in the world.
Today, five years after the market's bottom, that remains a long-term thesis for Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co., particularly after a first quarter that can most charitably be called "mixed." Thanks in part to continuing headlines about multibillion-dollar regulatory settlements, they continue to trade at below-average valuations compared to the broader group of large U.S. banks (and far below the shining stars of Canada).
There are, certainly, things to like in all three companies' financial results, and compelling cases that they are all buys – for the long term. That's because the question, unfortunately, is how long investors will need to wait until the banks' good news overshadows the bad, rather than vice versa.
"Legal and compliance expenses at some level will continue to be a fact of life for most large, complex banks for the foreseeable future," Morningstar analyst Jim Sinegal said in a note Wednesday after Bank of America reported a first-quarter loss thanks to unexpected litigation expenses. "We think there is increasing evidence that the costs of size are beginning to offset – if not exceed – any advantages related to economies of scale and scope at financial institutions."
It is important to point out, of course, that every bank that made it out of the financial crisis alive has rewarded those with the iron guts to buy at the lows. Bank of America, Citigroup and JPMorgan have all tripled or quadrupled since March 9, 2009. And the three did just fine in 2013, with each rising 30 per cent or more.
That momentum has stalled, however, with Bank of America eking out a slight gain so far this year and Citigroup and JPMorgan posting high single-digit losses, making them two of the worst performers among U.S. bank stocks.
A couple of years ago, in fact, it would have been insulting to lump JPMorgan in with this group, since the perception was that JPMorgan emerged from the financial crisis in great shape. That was before the London Whale, a massive derivatives-based trading loss.
Morningstar analyst Jim Sinegal initially viewed the loss "as a one-time aberration," but subsequent problems make him question whether JPMorgan has the conservative culture CEO Jamie Dimon has claimed. "Management's initial underestimation of last year's trading losses, the firm's recent need to add billions to its reserves for legal liabilities, and its need to resubmit [to regulators] its 2013 capital plan, along with a variety of penalties over the last year have justifiably shaken our confidence in the firm."
Wall Street analysts will excuse a certain amount of such things if a company is hitting its numbers – but JPMorgan, which reported April 11, failed to do that in the first quarter, missing estimates for revenue and earnings thanks to weakness in its mortgage and investment-banking business.
Analyst Gerard Cassidy of RBC Dominion Securities' U.S. arm cut his 2014 earnings estimate to $5.50 per share, but maintains his "outperform" rating. He suggests a "normalized" earnings number for the bank, which he sees occurring "further out," is $7.50 per share, and a price-to-earnings ratio of 10 on that number yields a $75 stock.
Mr. Cassidy, who despite the recent challenges calls JPMorgan "the best-managed money-centre bank of its size," says it has been steadily improving the credit quality in its lending businesses. At the same time, new regulations have reduced risk in its investment banking business. "Though the de-risking will cost the company in near term profitability, longer term it will reduce its volatility," he said in a note.
Citigroup, by contrast, beat analysts' expectations Monday with its earnings. That was good, because it counteracted a string of bad news earlier this year. The company revealed a $400-million fraud in its Mexican operations in February, then was embarrassed in late March when U.S. regulators blocked its plans to return capital to shareholders through a combination of dividends and buybacks.
Analyst Derek De Vries of UBS Securities, who had been looking for a dividend/buyback combo to serve as a catalyst for the shares, says he believes Citigroup can get approval for its capital plan next year – an important part of any bull thesis. In the meantime, however, the bank reached or exceeded all of its targets with its first-quarter earnings report, he says, and its sizable emerging-markets consumer business beat his forecast, which he said should assuage investors' fears about Citigroup's exposure to the developing world. His $60 target price suggests about 25 per cent upside. "Citi is the least expensive U.S. bank, it is arguably the best capitalized U.S. bank, and it is coming up on easy [second-half] 2013 [comparisons]."
Bank of America's results, released Wednesday, were frequently referred to as "noisy." That can happen when you tell investors you've reached legal settlements worth $3.7-billion, but then set aside $6-billion in a litigation reserve, leading to a loss. The shares were down, wiping out a portion of 2014's gains.
Analyst Joe Morford at RBC's U.S. arm argues that if you can look past the legal expenses, Bank of America reported stronger margins, lower expenses, better credit quality and higher capital ratios. He believes the company, which did have its capital plan approved by regulators, is on track to continue to boost dividends and buybacks in the coming years. His target price of $19 is about 18 per cent above current levels.
James Strecker a debt analyst at Wells Fargo (a bank that, thanks to its greater domestic focus, has avoided getting lumped in with these three) says that the long-expected increase in interest rates is what could truly drive earnings in the banking group. Since Bank of America has $2-trillion (that's with a 't') in assets, an expansion of 0.1 percentage points in its net interest margin could add another $2-billion in lending income per year.
"It's hard to get the timing right, but most folks would agree there's a positive earnings trend for most of these institutions," he said in an interview. "It's just a matter of the time-frame to realize them."