08 May 2006

US Banks at 25% Discount to Rest of the Market

Financial Post, Duncan Mavin, 8 May 2006

The U.S. banking sector is delivering record-busting profits and stellar growth of late. But bank stock valuations haven't caught up and are "too good and too cheap to ignore," says UBS Investment Research analyst David Bianco.

In the first quarter of 2006, Wachovia Corp., the fourth-largest bank in the U.S, posted a 7% increase in net income compared with the previous year, while SunTrust Banks Inc., the seventh-largest bank in the U.S., recorded net income up 8%. Yet valuations for those banks and others remain too cheap, said Mr. Bianco.

"Banks now trade at 11 to 12 times earnings, a 25% discount to the rest of the market," noted Mr. Bianco. "While discounts are typical for banks historically, this large discount exceeds history."

Canadian banks, by comparison, were trading at more like 13 to 16 times earnings in 2005. Though they are expected to trade a little lower in 2006, they will still likely be in the 13 to 14 times earnings range for this year, according to estimates from Royal Bank of Canada analyst Jamie Keating.

Of course, Canada is not the U.S. and the banking environments in the two countries are different. Still, Canadian investors can also factor into their investment decisions the beneficial exchange rate when considering U.S. stocks.

Mr. Bianco said his bullish view on U.S. bank stocks is because the banks occupy a "sweet spot" in the American economy.

In March and April, for instance, he notes the S&P 500 Financials reported an increase in earnings of US$3.2-billion, compared with a decline of US$1.5-billion for information technology companies, and a drop of US$320-million for energy companies.

He said the U.S. banks are benefiting from a range of factors. For instance, in comparison with other industries, banking is not under pressure from Asian competitors, and has relatively low exposure to soaring energy costs, noted Mr. Bianco.

Furthermore, banks, which rely heavily on electronic processing, stand to gain more than most from advancements in technology; they also have the expertise to exploit capital markets to reduce risk; and they have a high claim on the disposable income of Americans.

Mr. Bianco also downplayed the potential impact on the sector of the flattening yield curve.

The yield curve inverted in December, and stayed that way through most of January, when the yield on the U.S. two-year bond was higher than the yield on the 10-year bond.

In the past, this has been taken as a sign of a looming recession in the United States and so the recent inversion caused much hand-wringing among economists and investors alike.

But the yield curve "gets too much attention," said Mr. Bianco, and bank earnings are more robust than many investors think.