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Unloved U.S. financials rewarding the faithful

U.S. bank profits are racing past analysts' expectations but the sector still looks cheap. As financial institutions slowly emerge from the cloud of skepticism that has hovered over them ever since the financial crisis of 2008, investors may want to consider climbing aboard.

All 18 constituents of the S&P bank index have reported quarterly earnings in recent weeks and the results have been spectacular. Earnings per share for the sector were 81 per cent higher in year-over-year terms and 12 per cent ahead of analyst projections.

Unlike in previous quarters, the major investment banks joined the party. Citigroup saw profits rise 110.5 per cent and JPMorgan Chase raked in 80 per cent more than in the fourth quarter of 2011.

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The continuing rally in the sector has been a major surprise for portfolio managers. The Bank of America survey of professional money managers noted that portfolios had been underweight the bank sector in 2012. As a result, managers failed to benefit fully from its 31-per-cent rally during the year. By comparison, the S&P 500 climbed 16 per cent. In 2013, the strong performance has continued with the S&P bank index improving by 6.5 per cent.

Yet skepticism remains. Before 2008, U.S. banks traded at a price to tangible book value multiple – a conservative metric that compares the stock price to the value of assets in the event of bankruptcy – of between three and 31/2 times. The current level of 1.6 times suggests that investors' faith in the sector is still a long way below pre-crisis levels. Despite the rally, they still require a valuation discount before owning the stocks.

The regulatory environment in the banking sector is contributing to investor uncertainty. Negotiations surrounding the Dodd-Frank Wall Street Reform and Consumer Protection Act, a sweeping set of regulatory changes for the U.S. financial system, have already outlasted the bill sponsors – both Senator Chris Dodd and former House Financial Services Committee chairman Barney Frank have already left office. Despite the fact that the Dodd-Frank bill was passed into law in July of 2010, almost half of the stipulated provisions are still being argued in Congress before implementation. Analysts and investors will have difficulty projecting future profits until these discussions have been completed.

Much of the U.S. bank stock rally to date has been the result of stabilization in U.S. credit conditions. When credit markets are volatile, banks will withhold a percentage of profits in large pools as provisions against the possibility that customers will default on loans. As conditions improve, the banks will reduce provisions and count the funds as earnings. The process can have a huge effect on reported quarterly earnings growth. In 2012, for instance, Citigroup was able to recategorize $2.6-billion (U.S.) from provisions to profit according to Bank of America research.

The rally in U.S. bank stocks is likely to continue for as long as U.S. credit conditions improve. As memories of the financial crisis retreat into investors' rear-view mirrors, and no further debt disasters occur, valuation levels should slowly return to pre-crisis levels. The process leaves plenty of upside for investors in the sector.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More

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