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Jubak's Journal
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5 banks thrive in fat-cat suburbs
The deposits are rich, the loans are low-risk and there's a ready market for financial services. These old-fashioned banks will mint profits even as rates rise.
By Jim Jubak
Unsurprisingly, bank stocks havent performed well since the Federal Reserve started making noise about raising interest rates. The Standard & Poors Banking Index ($BIX.X, news, msgs) hit its high for the year on March 4. Since then, as the Federal Reserve has moved from patience before raising interest rates at its March 16 meeting, to talk of measured increases at its May 4 meeting, to an actual rate increase on June 30, the bank index has sagged 3% from that March peak.
Many individual bank stocks have done much worse. Washington Mutual (WM, news, msgs) is down 11% since March 4 on worries that higher interest rates would lead to lower revenue from originating mortgages and then packaging them for sale. Citigroup (C, news, msgs) is off the same 11% on worries that higher rates will slow growth and cut margins in its massive credit-card business. Smaller thrifts and banks have by no means been immune. Flagstar Bancorp (FBC, news, msgs) is down 21% in that period, and regional bank Fifth Third Bancorp (FITB, news, msgs) is down 10%.
And with worries about more interest-rate increases and, most likely, the rate increases themselves on tap for the rest of 2004, this would seem like the worst of times to recommend bank stocks to you.
Surprisingly, perhaps, thats exactly what Ill be doing in this column. Five times in fact.
Targeting wealthy suburbs
Not any bank stocks, mind you. There are good reasons to worry about the revenue and earnings growth at banks that have hung their strategies on gains from reselling mortgages, from massive increases in credit-card lending and from borrowing cheap money to buy higher-yielding Treasury bonds. In those parts of the industry, investors can expect more quarterly reports like that issued by Washington Mutual on July 21: In the second quarter, the thrift announced that net home-loan mortgage-banking income dropped to zero from $611 million a year earlier.
But there are banks that dont have to count on mortgage refinancings for their earnings growth, that dont raise capital by borrowing it and that dont have to worry that tapped-out consumers will stop borrowing, or, worse, stop repaying their loans.
These banks sit in some of the countrys fastest-growing areas, often in the wealthy suburbs of major cities. This gives them the ability to grow the old-fashioned way: by attracting an ever-increasing volume of deposits and making an ever-increasing number of loans. In addition, these banks cater to the needs of the population of wealthy and near-wealthy in their communities, which gives them another income stream from the fees they earn on products such as money management and trust services. (Full credit where credit is due: I first saw these two ideas put together in Bob Howards investment newsletter Positive Patterns. You can reach him and subscribe for $700 for the newsletter, addendum and e-mails or just $399 for the newsletter and addendum; and ask about rates on trial 90-day subscriptions at positivepatterns@prodigy.net.)
These bank stocks -- call them wealth/growth bank stocks -- arent immune from the selling pressures caused by interest-rate worries. But since their business is largely immune from the effect of interest-rate increases, any drop in these stocks is a buying opportunity for long-term investors. Investors can start slowly building positions now or wait for a month or three when I believe another round of interest-rate worries will take another bite out of prices in this sector.
Big numbers
What does a wealth/growth bank stock look like?
You can get a good feel from the latest quarterly earnings report from Bank of Marin (BMRC, news, msgs).
Heres the growth side of the bank. On July 15, Bank of Marin, which operates nine branches and "wealth-management services" in the San Francisco suburbs north of the Golden Gate Bridge, reported record earnings of $2.3 million for the second quarter, a 25% increase from a year earlier. Total loans were up 17%, and total deposits increased by 19%. By the way, the loan pipeline, which has been building since the fourth quarter, is now at a record high and the bank projects above-average loan growth for the year's second half.
But its not just the growth numbers that are impressive. Any bank can grow revenue if it cuts corners and any bank can grow income in the short term if it ignores little details like the credit worthiness of its borrowers. But Bank of Marin is keeping tight control, very tight control, over factors like these that are critical to its long-term success. The loan portfolio didn't contain a single nonperforming loan at the time of this report, and net charge-offs for bad loans total less than $70,000 for 2004 to date.
And heres the wealth side of the bank. Noninterest income -- what a bank earns from services that range from returning a bad check to managing a family trust -- grew by 33% in the year's first six months. That kind of jump doesnt come from raising ATM fees or bounced-check charges. Its a reflection of the extraordinary growth in that percentage of the population with $1 million or more in investable assets and their need for high-margin services. Northern Trust (NTRS, news, msgs), a bank that specializes in this wealth-management business, estimates that the part of the population with that kind of assets is growing at about seven to eight times the growth rate of the population as a whole.
But it doesnt do any good to just add expensive services if it drives up the banks costs. The toughest challenge is delivering wealth-management services at a profit. Here, too, Bank of Marin seems to have found a solution. In the year's first half, when noninterest income grew by 33% remember, noninterest expense grew by just 4.5%. This helped drive the banks return on assets to 1.33% from 1.27% in the first six months of 2003. (These numbers by themselves dont mean much unless youre a banker. But heres a good benchmark: The trailing 12-month return on assets at Northern Trust, no slouch in this business, was just 1.1%.)
Adding to your portfolio
Let me give you the names of a few other wealth/growth bank stocks to add to your portfolio as interest-rate worries create buying opportunities. Id recommend Northern Trust for investors who want to get their feet wet in the sector with a big-capitalization stock (well, at $8.7 billion it is big for this sector) that's widely followed on Wall Street, which makes it easy to get multiple research opinions. The stock is a solid buy below $40.
Youll get more leverage with a smaller bank, of course, but some of these are, to put it mildly, underfollowed on Wall Street. Bank of Marin, with a market capitalization of just $133 million, isnt followed by any analysts that I could find. In fact, I wasnt able to find an analyst's report on the stock more recent than 2001. Middleburg Financial (MBRG, news, msgs), located in the wealthy Virginia horse country near Washington D.C., is about the same size with a market capitalization around $122 million. Zacks Investment Research lists one analysts earnings estimates for the stock. Bank of Marin and Middleburg Financial are off their 52-week highs by 12% and 27%, respectively.
Wintrust Financial (WTFC, news, msgs), which specializes in the wealthy Chicago suburbs, just hit a 52-week high. The stocks price-to-earnings ratio of 24 is at the high end of its 10-year range, so I might watch and wait on this one. The stock has a market capitalization of $1.1 billion. First Oak Brook Bancshares (FOBB, news, msgs) is smaller at a market capitalization of $289 million, but plays in the same wealthy Chicago suburbs. It is now about 11% off its 52-week high and sells at a P/E ratio of 16.
I dont think youll be unhappy with your investment over the long term if you buy any of these stocks at current prices. But if bank stocks havent exactly rallied in the last month, theyve at least stopped going down as investors have started to worry more about the possibility of slowing growth and less about rising inflation and interest rates. The S&P Banking Index was flat from June 28 through July 27.
Thats likely to change just because this economy is so hard to read and were about due for a new set of numbers that will send opinion back in the other direction. When investors next start to worry about interest rates and when you see lots of stories in the media about what the Federal Reserve will do next, dust off this column and put some money into bank stocks like these.
Changes to Jubaks Picks
Sell BP
I think this stock is hitting a short-term peak. Its time to sell with an eye to picking up the shares again after any retreat. Long-term investors should ignore this sell and just hold on since BP (BP, news, msgs) is one of the best ways to ride long-term energy trends. As the company said in its July 27 earnings report, oil prices for the second quarter of 2004 averaged $35.32 a barrel for benchmark North Sea Brent crude, the highest price of any quarter in the last 20 years and 10% higher than in the first quarter. In light of those prices, Id have to say that BPs second-quarter results were mildly disappointing. Yes, earnings per ADR rose to $1.14, a penny above Wall Street estimates, and production increased by 18% from the second quarter of 2003. But BPs margin per barrel is only $1.65 higher than it was a year ago, despite an average increase in oil prices of $9.50 a barrel.
A couple of other near-term events lead me to my decision to give this stock a rest. BP bought back $3.3 billion shares in the first half of 2004, and another $500 million in July, but those buy-backs, which support the stock price, have to go on hiatus from Aug. 21 through Sept. 19 by the terms of the deal that created the TRN-BP Russian oil joint venture. The company also faces higher Russian taxes on that joint venture in the next two quarters. Total return (with dividends) from BP since I added it to the portfolio on Feb. 13, 2004, is 17%. (Full disclosure: I will be selling my shares of BP three days after this column is posted.)
New developments on past columns
8 stocks to watch in a wandering market
PepsiCo (PEP, news, msgs) reported earnings of 61 cents a share, a penny better than Wall Street expected. But like so many stocks during this earnings season, PepsiCo shares retreated when the company didnt increase its earnings projections for the year, leaving them at $2.29 a share for 2004. Apparently, delivering yet another year of double-digit earnings growth -- 12% to be exact -- isnt enough. The shares fell by 2% from July 15 through July 28. Well, its good enough for me, especially since that recent price decline has created an opportunity to add to positions in the world's salty-snack leader. As of July 30, Im upping my target price to $61 by December 2004, on the good news in this quarters earnings report. What good news? 1) A 1 percentage-point gain in market share for salty snacks in the North American market by the companys Frito Lay division. Not easy when you already have 60% of the market. 2) An impressive 60 basis-point gain in companywide operating profit margin. 3) And a very solid 13% gain in sales by the companys international operations, which provided about half of the companys profit growth in the quarter. The international business is, I believe, PepsiCos growth engine for the future. 4) Identifiable problems in sales at the Quaker snack business; the company believes sales should improve in the second half of 2004. (Full disclosure: I own shares in PepsiCo.)
3 techs that could buck the market tide
The bounce that I was expecting from earnings season among technology stocks hasnt materialized in any way, and the technical tide running against the sector has been frighteningly strong. Two of my three technology picks, Analog Devices (ADI, news, msgs) and Marvell Technology Group (MRVL, news, msgs), are now down 14.9% and 10.4%, respectively. The third, Micron Technology (MU, news, msgs), is up 1.8%. And its certainly hard to say that this market, especially this market for technology stocks, has hit a bottom and is ready to turn around. The Nasdaq Composite ($COMPX) has tested and retested important support at 1,840 in recent days, but its certainly still too early to say that this support has held. Wall Street is deeply divided between those who think the sector has further to fall because, they believe, inventory levels are running well ahead of demand for the third quarter, and those who think the semiconductor sectors 30% decline from its January 2004 highs is way overdone considering the strength of the economy.
I admit to falling into the second camp: I think the selling of technology stocks with solid sales growth and solid product demand, which is by no means every stock in the sector, is overdone. The market tends to go through this revulsion on second-quarter earnings every year and to get over it in the fall. I think this is simply a worse-than-average case of those same seasonal jitters exacerbated by the very real difficulty in reading this economy. (On that, see below). Im going to hold onto my positions in these three stocks, not least because they arent due to report earnings until Aug. 12, Aug. 19 and Sept. 22, respectively. By that time, the market might be willing to respond to the solid growth that I believe these stocks will deliver. On the other hand, I could be wrong and this is a relatively high-risk bet. There is certainly no point in following these stocks lower and lower, and more conservative investors should figure conventional stop-loss measures into their thinking: The usual advice is to sell when a stock has declined by 15% or so in order to limit losses.
Profit off the Streets hopes and fears
Were definitely in the fear stage of the cycle: Right now, the stock market is selling off on any news that sounds bad, even when on analysis it isnt. Take the durable-goods numbers reported by the Commerce Department on July 28. The report, which sent the market down again, said that new orders for durable goods climbed 0.7% in June instead of the 1.5% Wall Street had expected. But dig a little deeper and you see the Commerce Department also revised the May durables number to show a drop of 0.9% instead of the earlier 1.8% drop. Revising Mays numbers upward, of course, has the effect of reducing Junes growth. The actual level of orders for durables was pretty much as expected. The market is jumping first and asking questions later these days. Exactly what youd expect when no one knows whether the economy is growing fast enough, too fast or too slowly. But none of this volatile short-term data will really give us the answer to that, as much as we wish for it.
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: Analog Devices, BP, Micron Technology, and Pepsico. He does not own short positions in any stock mentioned in this column.
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