(Forbes) After reading Warren Buffett applied for permission to add to his 10% Bank of America holding, I scratched my head, then read Bank of America’s quarterly report. Net income totted up to $7.5 billion, its pretax income approximating last year’s quarter. But earnings per share rose 14% because of shrinking shares outstanding, some 8% lower, year-over-year and easing taxes.
Share buybacks have become religion for major bank management. The shrink at Citigroup is even more dramatic. Year-over-year, pretax profits eased 1% but net per share rose handily, some 17%, because average diluted shares declined 10%. This is an ongoing priority for Citigroup. Management is explicit that buybacks remain in place for years to come.
For Citigroup, on $20 billion in annualized earnings power, let’s say $10 billion is available for buybacks. With its stock at $70, Citigroup’s market cap is around $160 billion. An annual shrink of 6% seems in the cards. The stock still ticks around nine times earnings, slightly below book value.
This is a different Citigroup than what I remember from the 2008-2009 meltdown. They then performed a reverse split to retrieve their stock from an impolite low-single digit number. On an adjusted basis Citigroup’s 2006 high of $560 is unlikely to be reached over the next 20 years, assuming 10% compounded growth in earnings and share price.
I may be a touch uncharitable because Citigroup sells under 10 times earnings in a market ticking at 18 times earnings. Should the entire financial sector including brokerage houses and credit-card purveyors sell at a huge market discount?
Maybe this is what percolates in Warren Buffett’s brain, but he never goes public with such a concept. A while ago, he added to Wells Fargo (a mistake) and now Bank of America is on the table for discussion with the regulators. Bank of America sells at 10 times earnings. It took control of Merrill Lynch in the financial meltdown. On $30 billion in current earnings power Bank of America, net of dividends, could allocate a buyback on its market capitalization of $270 billion, nearly $24 billion per annum. Likewise, with Citigroup, Bank of America’s buyback could shrink shares by 8% per annum with its stock at $30.
When we get to JPMorgan Chase, its history in the 2008-2009 meltdown is markedly different. Jamie Dimon steered his bank comparatively clear of the disaster in flimsy mortgage-backed securities. The bank never succumbed to the precarious plight of Citigroup, but the stock did dip below $20 a share in 2009. At $120 now it ticks at twice its previous high over $60, set in 2000.
JPMorgan’s present market value near $400 billion, rests in new high ground. Its dividend yield is richer, near 3%, but price-earnings ratio is a premium to most banks, at 12 times earnings, not 10 times. Still, the share buyback, annually, is ample at $28 billion. Maybe a shrink of 7% per annum is likely. JPMorgan sells at two times tangible equity, a wide premium over most banks.
JPMorgan sells at two-thirds of the S&P 500 Index’s multiplier. Seems comparatively low. The stock’s price-earnings ratio could work higher in a reasonable environment for the economy, with some expansion, not compression of net interest margins. As a stock it might elevate to over 14 times earnings. I see this happening, maybe not overnight, but over three years. The market may wait and see how banks manage through the next recession in terms of loan losses and revenue compression across all asset sectors. If bank stocks show just 6% earnings growth with something from closing part of the disparity with S&P 500 Index valuation, I see 12% per annum share appreciation possible.
Consider, half of Berkshire Hathaway’s portfolio rests in financials, mainly bank stocks and American Express. Wells Fargo, its biggest position was added to not so long ago and now Buffett wants to take up his 10% position in Bank of America. Wells Fargo’s pettifoggery, overcharging clients for services pulled out of a hat, cost them a big fine (billions) handed out by the Federal Reserve Board. There’s a new headman now. Wells Fargo trades in the middle of its 12-month range, an indifferent performer compared with Citigroup, JPMorgan Chase and Bank of America.
Banks do inflict torture on some of their needy clients. For example, interest on credit card debt can range between 15% and 17%. I’ll never forgive JPMorgan for denying me a 50% mortgage on my Hudson Valley spread. (They didn’t like one-of-a-kind properties.) Sandy Weill, headman at Citigroup, an old, old friend, said: “Marty. You write the mortgage terms and I’ll sign the document.”
Banks have grown their asset management business, but I’m unhappy with recent years’ performance, several lagging their benchmark of 60% equity, 40% fixed income. I see this as a finance committee chairman in a couple of endowment funds. JPMorgan’s miss was underweighting large capitalization growth stocks in the S&P 500 Index.
They and others use a pie-chart construct which has them dabbling in everything under the sun inclusive of gold and emerging market debt. Additionally, they farm out a sizable percentage of clients’ assets. So, there’s more management fees entailed.
I own Citigroup, Charles Schwab and Bank of America - 17% of my portfolio. So, I’m around 30% overweighted in financials, which is a 13% weighting in the S&P 500. I’m at 31% in internet properties and technology, which is near a 50% overweighting. Buffett, allergic to high-multiple properties, solved this problem by overweighting Apple. So, far, so good.
As for bank operating earnings outlook, I’ll be happy with flattish numbers next 12 months. No chance of earnings leverage with flat net interest margins and no asset growth. Ironically, if bankers manage through a recession largely intact, their stocks will levitate towards closing the wide negative gap in valuation with the market.
Consider, Berkshire Hathaway sells at 1.5 times book value. Better buy bank stocks directly, selling near book value. Dialing back to Nifty Fifty times, 1972, First National City Bank, the old Citigroup, sold it 20 times earnings. Walter Wriston, its revered headman, promised the Street mid-teens earnings growth ‘til the end of time. The bank was structured to make it happen, he said.
I remember buying Bank of America’s $25 par preferred stock at five bucks. Buffett negotiated a boatload of warrants by providing Bank of America with billions in much-needed liquidity. Berkshire made billions on its warrants. For me, there’s everlasting push-pull between my memory of banker stupidity vs. future possibilities of rising price-earnings ratios. I remain the cowardly lion, slightly overweighted in financials.
Ironically, bank stock earnings growth is incidental to the potential of price-earnings ratio elevation. I’m sure this is what Buffett sees. In Berkshire’s equity portfolio nearly half of assets rest in the financial sector, over $100 billion with unrealized gains of 100% therein. Grossed up to market value on insurance and reinsurance operating properties to 10 times investment income, adds $60 billion to concentration in financials.
Individual investors can buy Bank of America directly without asking the government’s approval. Paying a 50% premium over book for Berkshire doesn’t make much sense.
