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A market-beating financial stock for 2005
Despite rising interest rates, many financial stocks had a solid year in 2004 -- and should continue to pay in 2005. Heres what the winners had in common, and the one I'd buy right now.
By Jim Jubak
A funny thing happened to financial stocks in 2004: The Federal Reserve boosted interest rates, but stocks didnt plummet. In fact, financial equities had a pretty good year even as the Fed raised its target for short-term interest rates to from 1% to 2.25%.
Theres a lesson for investors here: The spread between the interest rates banks pay for capital and the interest rates they charge to lend capital matters more than the absolute level or direction of interest rates.
That explains the gains financial stocks posted and convinces me that Bank of America (BAC, news, msgs), U.S. Bancorp (USB, news, msgs), Main Street Banks (MSBK, news, msgs), Capital One Financial (COF, news, msgs), and MBNA (KRB, news, msgs) will deliver above-market returns for 2005.
Ill return to the future of those five stocks in a moment, but first lets take a closer look at how some big financials did last year.
Pockets of outperformance
At first glance, the year was solid but not spectacular for investor favorites in the sector. Citibank (C, news, msgs) was up 3%, Washington Mutual (WM, news, msgs), 10% and BofA, 18%. But there were pockets of huge outperformance: Credit card companies Capital One Financial and MBNA returned 44% and 37% respectively; regional banks Main Street Banks and Commerce Bancorp (CBH, news, msgs) returned 34% and 24% respectively; and perhaps most surprisingly, some thrifts that depend on mortgage lending soared, including Golden West Financial (GDW, news, msgs), which returned 44% for the year.
These returns werent evenly distributed over the year, however. If you break down the performance for Citigroup, for example, youll see the stock climbing to a high on April 1, and then sinking to a low on Oct. 22 before climbing again. Washington Mutual roughly shows a similar pattern with a high on March 1, a low for the year on Aug. 12, and a retest of that low on Oct. 20. From the high to the October low, Citigroup lost 17% and Washington Mutual dropped 15%. But from the October low to the close on Dec. 31, the stocks gained 14% and 13% respectively.
The charts of the big gainers for 2004 that I mentioned above show a similar pattern but with an earlier low for the year -- on May 10 for BofA, Golden West Financial and Main Street Banks -- and a longer and stronger run to the end of the year. Stocks like these simply never looked back.
That pattern is pretty easy to understand -- with the benefit of hindsight, of course. The drop to the lows of March, April or May was a result of anticipation that the Federal Reserve was about to raise interest rates, as the central bank did on June 30, when it took its target short-term interest rate up to 1.25% from 1%. The months of stagnation that followed for Citibank and Washington Mutual were the result of worries that the Fed would raise rates more quickly than indeed turned out to be the case. And the gains from May or October came as investors realized that Alan Greenspan & Co. were indeed serious when they said that rate increases would be measured. Financial stocks, the consensus came to realize, didnt face the kind of interest-rate spike that has devastated the sector in the past.
A not-too-shabby spread
Rapidly rising interest rates can cause serious trouble for banks. The biggest problem occurs when the value of a banks interest-rate-sensitive assets -- mortgages and bonds -- drops; secondly, profits can quickly disappear when the difference between the short-term interest rates banks pay for money and the long-term interest rates banks charge to lend money, known as the spread, contracts.
But, remarkably in 2004, with the Fed raising short-term rates to 2.25% from 1% neither problem surfaced. The yield on a long-term 10-year Treasury note was about 4.25% at the beginning of 2004, and it finished the year at 4.25%. The long-term assets in bank portfolios didnt plunge in value overnight.
And, while interest-rate spreads narrowed, they didnt collapse. The average historical gap between short-term interest rates and the yield on the 10-year Treasury is about 1.1 percentage points. Before the Fed began to raise rates, the gap had climbed to more than 3 percentage points. Borrowing money at short-term rates, as banks do in the commercial-paper market, and then lending long (or buying Treasury notes) produced easy profits. No one expected that to last forever, or course, and the fear among investors was that the smooth ride would come to a screeching halt. Instead, the spread remained far wider than the historical average. At the moment, the spread remains a very comfortable 2 percentage points. Not as profitable as a 3 percentage point spread, certainly, but none too shabby, either.
Even that kind of relatively benign interest-rate environment wasnt without its challenges, and not every company was equally well positioned to meet those challenges. A number of banks and thrifts, Washington Mutual, for example, had developed a business model that was so leveraged to interest rates that they couldnt escape the year without some damage. An aggressive acquisitions strategy had turned Washington Mutual into a mortgage-lending machine that was heavily dependent on generating a very high volume of new mortgages. It took only a very slight cooling off in mortgage originations and refinancings to force Washington Mutual to sell some of its home-lending centers to American Home Mortgage (AHM, news, msgs) in an effort to cut expenses. The company missed Wall Street earnings estimates when it reported second-quarter earnings, as net income from its home-mortgage business went to zero from $611 million in the second quarter of 2003. That startling decline came about because in 2003, Washington Mutual had been able to make a profit by selling packages of mortgages that it had originated for a higher price, thanks to falling interest rates. With rates moving up, those gains disappeared.
What it took to win in 2004
Bank and thrift stocks that performed the best in 2004 shared similar traits: In general, they were more conservatively run, they watched expenses, they weeded out credit risks, they built sizable consumer deposits that provided a cheaper source of capital and high-fee income, and they ran flexible consumer credit card businesses that allowed them to increase rates ahead of any interest-rate hike from the Fed.
For example, Bank of America leapt ahead of the competition in the race to become the first truly national consumer-banking franchise when it bought FleetBoston. With banks and ATMs in 21 states, the company became a deposit-gathering machine. On the cost front, the bank aimed to generate $250 million in cost savings in 2004, and a total of $1.5 billion by the end of 2005.
U.S. Bancorp has turned into a specialist in generating fee-based business from its customers as it has rapidly expanded into lines such as asset management (through the 2002 acquisition of the corporate trust business of State Street (STT, news, msgs)). About 40% of revenue comes from fee-based businesses.
Capital One Financial trimmed its credit card loan delinquencies, which in turn reduced the amount of money it set aside for loan losses. That unencumbered cash eventually showed up as increased earnings. That improvement in credit quality has come even as the company has continued to build its share of the market for Visa and Mastercard credit cards.
MBNA was able to improve an already strong credit quality. And, of course, as is the case with Capital One as well, credit card companies are easily able to keep the rates they charge to card holders well ahead of any increases in short-term interest rates.
And finally Main Street Banks, a stock that I added to Jubaks Picks on Sept. 10, is a prime example of a local bank that has built a consumer deposit and business-lending franchise in a targeted geographic market. That specialization gives the bank access to the best of the trends that Ive mentioned here: consumer deposits, high fee-based income, an ability to keep a close eye on costs and a loyal customer loan base with high credit quality.
U.S. Bancorp stands out for 2005
This year isnt going to be a complete replay of 2004, of course. For instance, some regions of the country, New York and Texas to take two examples, engaged in a virtual orgy of branch-bank openings in 2004. Were likely to see a contraction first in profitability at those branches, and then in the number of brick-and-mortar branches themselves. Commerce Bank is a master at opening profitable branches, but Im going to give the shares a pass in 2005 until some of their less-adept competitors go through their branch shakeout. Thrifts like Golden West Financial and Doral Financial (DRL, news, msgs) are just too expensive for me right now, even though Golden West is, in my opinion, the best in the adjustable-rate mortgage business. The odds are that some competitor, probably in the sub-prime sector that specializes in mortgages for customers with less-than-ideal credit ratings, will blow up in 2005. Thats when Id like to buy Golden West.
With this column, though, I am going to add U.S. Bancorp, one of the winners of 2004, to my Jubaks Picks portfolio, because I think this bank is well-positioned to be a winner again in 2005. And in this stock market, I certainly dont mind that the shares pay a 4% dividend, either.
In my next column, Ill look at how you can manage your own interest-rate spread to make your debt pay.
Changes to Jubak's Picks
Buy U.S. Bancorp
Im adding U.S. Bancorp (USB, news, msgs) to Jubaks Picks for what it is and for what it isnt. On the is side of the ledger, this is a bank that has become a specialist in generating fee-based business. About 40% of revenue comes from that source. That business has been growing nicely, accounting for much of the 9% earnings growth year to year, although that growth has been obscured by losses on the banks investment portfolio and problems in its commercial loan portfolio. Now that those losses and problems seem to be behind the banknon-performing commercial loans were down 50% in June from the level in June 2003)I think earnings growth will kick up above 10% for 2005. Investors can also count on a 4% dividend and the likelihood of future dividend increases like the 25% hike that companys board voted in December 2004. On the isnt side of the ledger, the bank doesnt have much exposure to the risks of the home mortgage business: about 10% of the companys non-interest income comes from mortgages. And with the spin off of investment house Piper Jaffray in 2003 and the acquisition of the corporate trust business of State Street (STT, news, msgs) in December 2002, U.S. Bancorp also lowered its business risk. As of January 18, Im adding shares of U.S. Bancorp to Jubaks Picks with a December 2005 target price of $36 a share.
New developments on past columns
Schwab, Pfizer fail the Clean Stocks test
Heres news of another misstep by Pfizer (PFE, news, msgs), a company thats making a lot of them recently. On Jan. 12, the U.S. Food and Drug Administration warned Pfizer about problems with the ads for its embattled COX-2 painkillers Celebrex and Bextra. A letter from the FDA said that television and print ads for the drugs failed to include important information about risks of cardiovascular problems including heart attacks and strokes, and made misleading or unsubstantiated claims about safety and effectiveness. A Pfizer spokeswoman told The Wall Street Journal that the Celebrex ads cited by the FDA were no longer running.
5 little-guy oil sector winners
On Jan. 11, Penn Virginia (PVA, news, msgs) announced its capital-spending plans and its oil and gas production targets for 2005. The companys board of directors approved a capital budget of $146 million for 2005, an increase of about 15% above spending in 2004. The company expects to fund its capital budget from internal cash flow. About 70% of the budget will go to developing approximately 170 new wells in Appalachia, Mississippi, east Texas and northern Louisiana. (The remaining 30% of the budget will go for exploration.) Penn Virginia now estimates oil and gas production for 2004 will come in at 24.5 billion cubic feet equivalent, a 3% increase from 2003 production, and that 2005 production will increase to between 25.5 and 27.5 billion cubic feet equivalent, an increase of between 4% and 12% over 2004 production.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Main Street Banks and Penn Virginia. He does not own short positions in any stock mentioned in this column.
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