As I mentioned last week, with danger lurking among energy master limited partnerships (MLPs) and real estate, income investors are increasingly looking elsewhere. And that includes a tried-and-true dividend generator – the banking sector.
But beware: Not all of them represent good income investments.
Large banks are now over-regulated and could be caught up in an international crisis.
Meanwhile, small- and medium-sized banks face some headwinds.
For example, credit scoring, risk management, asset and liability management, and other banking essentials all require a substantial investment in IT systems and the people who manage them. And those investments aren’t cheap, putting a dent in smaller banks’ smaller profits.
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Furthermore, local banks are subject to the vagaries of that particular locality. The bankruptcy of a single large employer can cause credit difficulties among that employer’s staff, as well as its suppliers and service providers.
However, for larger banks, the economies of scale aren’t there. They tend to involve themselves in investment banking business, which involves a level of risk management that many banks have failed to master. Just look at JP Morgan Chase & Co.’s (JPM) losses in 2012 on the “London Whale” trading business.
The standard benchmark for bank profitability used to be a 10% return on equity. Nowadays, regulators usually force banks to hold more equity than before, reducing returns.
With long-term interest rates around 2%, a 10% “hurdle” rate is now far too high. And it implies an equity risk premium of 8% rather than the historically normal 4% to 5%. So if you benchmark banks at a 7% return on equity, some bank stocks are undervalued.
You want a nice cushion in a bank’s earnings to ensure that when problems arise, the bank doesn’t fall into trouble.
As income investors, we’re interested in a high dividend yield. Accordingly, I’ve looked at all the banks with a dividend yield of 4% or more.
Many such banks have very low returns on capital. Indeed, some pay dividends in excess of net income. So I’ve further limited our search to banks with a net return on equity of 7% or more.
Surprisingly, this rules out more than half of the high-dividend banks, indicating that the sector is failing to earn an adequate return.
Some of the largest banks also tend to repurchase shares, further limiting our options. This is a shareholder-hostile tactic in an industrial company, and even more so at a bank, where adequate capital in a recession is the key to survival.
The two highest yields on U.S. bank stocks are foreign behemoths HSBC Holdings Plc (HSBC) and Lloyds Banking Group Plc (LYG), both of which yield more than 5%.
However, Lloyds’ return on capital is a measly 1%, while HSBC Holdings has a return on capital that only just meets our 7% criterion. Given the additional risk of holding these foreign behemoths, I suggest passing on them.
The highest dividend available on a bank that meets our criteria is the 4.8% from PacWest Bancorp (PACW). PacWest is based in California, where it has 80 branches. It also has one branch in North Carolina.
It has a return on equity of 7.9% and assets of $21 billion. Its $0.50 quarterly dividend is covered about 1.4 times by earnings, and it’s trading at a reasonable 1.1 times book value and 14.7 times earnings.
There are three other banks with dividend yields above 4% and returns on capital above 7% that also appear potentially attractive:
Finding solid income investments in today’s current market environment can be daunting, but it’s not hopeless. Know where to look, and tread carefully.
Good investing,
Martin Hutchinson
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