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TheStreet Open House

Buffett Buyback Math Key to Post Stress Test Bank Earnings

Updated to include stress test results

NEW YORK ( TheStreet) -- There is a way to tie a final set of Federal Reserve bank stress test results to the industry's long-term growth prospects.

The key hinges on the investing mathematics preached by Warren Buffett of Berkshire Hathaway (BRK.B) and the Fed's approval of capital returns to investors.

In the final piece of the 2013 stress tests, formally known as the Comprehensive Capital Analysis and Review or CCAR, the Fed has approved plans by most of the nation's largest banks to either boost dividends, buy back shares or do both, in what represents growing momentum of capital returns to investors.

While some have criticized a seeming monomaniacal focus on bank capital returns over the industry's long-term earnings prospects in this year's stress test jockeying, there is a way to tie the two together.

Investors might do well to hunt for banks that are using Fed-governed capital returns to grow their bottom line by shrinking overall shares. Given a still uncertain earnings environment for Wall Street titans and Main Street lenders, net buybacks that drive share counts lower could help drive overall earnings per share growth in 2013 for a handful of banks.

In that scenario, American Express, US Bancorp, State Street and Bank of New York Mellon appear to be a clear winners, given their mix of share buybacks and dividend increases. American Express will be buying back $3.2 billion in shares a starting in the second quarter, while its quarterly dividend will rise 15% to 23 cents.

At State Street, buybacks will be $2.1 billion as its dividend climbs to 26 cents a quarter. US Bancorp will buy back $2.2 billion in shares and pay a 23 cent quarterly dividend, while Bank of New York Mellon will buy back $1.35 billion in stock a quarter and boost its payout 15%.

JPMorgan Chase and Goldman Sachs both received "conditional approval" for their capital plans, with the Fed requiring both companies to submit revised capital plans "by the end of the third quarter to address weaknesses in their capital planning processes."

A focus on buying back shares cheaply to create room for earnings growth would be straight from the investing playbook of Warren Buffett, who spent a significant piece of Berkshire Hathaway's 2011 annual letter detailing why stalling stock gains at IBM (IBM) and an aggressive share buyback authorization play to investors' favor.

The logic Buffett applies to his IBM investment also may be a crucial aspect of Berkshire's large stock investments in the banking sector, including big positions in American Express (AXP), U.S. Bancorp (USB) and Wells Fargo (WFC - Get Report), to a lesser extent, given a lack of clarity on share buybacks.

A Jan. 14 analysis by bank research firm KBW shows that among banks submitting capital plans to the Fed, there are just five large banks that have been able to consistently reduce their share count through share repurchases in the wake of the crisis, including American Express, U.S. Bancorp, Bank of New York Mellon (BK), Goldman Sachs (STT) and State Street.

In contrast, firms such as Bank of America (BAC - Get Report), Morgan Stanley (MS) and SunTrust (STI) have seen share count growth exceed asset growth, according to KBW's analysis.

"Looking forward, capital management will be critical in a slow-growth, highly regulated, banking world, in our view, and the most successful banks will need to be reducing shares outstanding to achieve strong EPS growth," KBW analyst Fred Cannon wrote.

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