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TheStreet Open House

5 Cheapest Bank Stocks (Update 1)

Stocks in this article: BACCJPMDFSCOFBPOPFRCEVERSBNYEVTCI:BKX

Updated from 7:10 a.m. ET with comment on Everbank from Sterne Agee analyst Peyton Green.

NEW YORK ( TheStreet) -- The stock market rally -- led by the financial sector -- can't go on forever, so long-term investors need to dig a bit further to find value.

A few years ago, when banks had clearly turned the corner from the credit crisis, it was fairly easy for investors to identify strengthening banks trading for less than tangible book value and at rather low multiples to forward earnings estimates. With the KBW Bank Index (I:BKX) rising 31% this year through Friday, which followed a 30% rally during 2012, things appear to be getting a little "hot."

Based on second-quarter results, the earnings improvement for banks has decelerated. Rafferty Capital Markets analyst Richard Bove, in a note to clients on July 25, wrote that for "the vast majority" of banks with total assets in excess of $25 billion "there was no improvement in core earnings but a significant improvement in reported earnings" for the second quarter.

"The psychology today is that banks can do no wrong and the stocks are being aggressively purchased," Bove wrote. He added that "these stocks are still cheap," and that they "should be bought," but he also said investors need to "look for those that have shown core earnings growth."

Bove also warned that "at this moment, it appears that any bank stock will do as long as it has the name 'bank' in it. That is dangerous investing."

Most banks have continued a rather depressing focus on cost-control, during an extended period of generally weak demand for favored loan types and narrowing interest margins (NIM), as the Federal Reserve has kept the short-term federal funds rate in a range of zero to 0.25% since the end of 2008. The Federal Open Market Committee has repeatedly stressed that this "highly accommodative" monetary stimulus policy will likely remain appropriate at least until the U.S. unemployment rate drops below 6.5%. On Friday, the Bureau of Labor Statistics said the unemployment rate during July improved to 7.4% from 7.6% in June, so it would appear the banks will be kept waiting quite some time for the parallel rise in rates that will be brought about when the federal funds rate is finally raised.

Taking It Out to 2016

KBW analyst Christopher Mutascio last week looked ahead three years to estimate "normalized" earnings for large-cap banks in a more favorable interest rate environment. The analyst considered two scenarios for large-cap banks' net interest margins. The first scenario assumed no margin expansion from second-quarter levels, through 2016. The second scenario was termed "most optimistic, with substantial NIM expansion," while the third scenario generally assumed "the midpoint between the current and 20-year median NIMs."

Based on 2016 earnings estimates under the third scenario, Mutascio concluded that Bank of America (BAC) and JPMorgan Chase (JPM) were the cheapest large-cap bank stocks among companies covered by KBW.

Bank of America shares closed at $14.85 Friday and traded for 8.0 times Mutascio's earnings estimate of $1.85 a share for 2016. JPMorgan closed at $56.49 Friday, or 9.0 times Mutascio's 2016 EPS estimate of $6.30 under the third scenario.

For long-term investors who can make a commitment for at least three years, Bank of America and JPMorgan Chase have certain "advantages" that can create opportunities.

Some investors are shying away from Bank of America because the company seems likely over the next year or two to book additional extraordinary charges, as it settles mortgage repurchase claims with institutional investors. The bank restated its first-quarter results to reflect a $1.6 billion charge tied to its mortgage putback settlement with bond insurer MBIA (MBI), lowering Bank of America's first-quarter earnings by $1.1 billion, or 10 cents a share, to $1.5 billion, or 10 cents a share.

Bank of America reported unresolved mortgage repurchase claims against the company for loans originated between 2004 and 2008, of $16.648 billion as of June 30.

Some investors are steering clear of JPMorgan Chase too, despite the company's strong profitability because of continued headline risk from multiple regulatory investigations and the still uncertain political environment for the biggest banks. JPMorgan last week agreed to pay $410 million to settle charges of energy market manipulation by the Federal Energy Regulatory Commission. The company had previously announced it was considering "strategic alternatives" for its physical commodities business.

How About Focusing on Quality?

For long-term investors looking for quality picks among smaller, rapidly growing regional banks, two names that keep cropping up are First Republic Bank (FRC) of San Francisco and Signature Bank (SBNY) of New York.

First Republic's shares closed at $44.35 Friday and traded for 14.1 times the consensus 2014 earnings estimate of $3.14 a share, among analysts polled by Thomson Reuters. The consensus 2015 EPS estimate is $3.39. The bank on July 17 reported second-quarter earnings of $113.7 million, or 77 cents a share, increasing from $97.9 million, or 60 cents a share, during the second quarter of 2012. The bank said "excluding the impact of purchase accounting, core net income was $97.1 million, up 37% from last year." First Republic had $30.7 billion in loans as of June 30, growing 20% from a year earlier.

FBR analyst Paul Miller rates First Republic "outperform," with a $48 price target. In a note to clients following the earnings announcement, Miller wrote "based on the company's existing meaningful excess capital and cross-selling capabilities," he expects the jumbo mortgage specialist "to execute its growth strategy successfully in the coming quarters."

Signature Bank's shares closed at $93.70 and traded for 18.4 times the consensus 2014 EPS estimate of $5.09. The consensus 2015 EPS estimate is $5.76. The bank reported second-quarter earnings of $53.6 million, or $1.12 a share, increasing from $45.3 million, or 96 cents a share, a year earlier. The bank's net portfolio loans grew 13% year-over-year, to $10.9 billion as of June 30.

Oppenheimer analyst Terry McEvoy rates Signature Bank "outperform" with a 12-18 month price target of $100, and in a note to clients on July 23 wrote, "Signature's operating model continues to gain momentum in the New York market place with four new banking teams hired and ~$700M of loan growth in the most recent quarter. The move up in long-term rates is a positive to future securities yields and commercial real estate loan pricing has improved implying a more favorable outlook for Signature's net interest margin." The analyst expects earnings growth of 12% next year for Signature Bank.

But a focus on quality names with strong loan growth may not necessarily lead to the strongest returns. After all, Bank of America's shares have returned 28% this year through Friday, after more than doubling last year.

Cheapest Forward P/E

For long-term investors looking for the cheapest bank stocks relative to forward earnings estimates, regardless of any other factor, we have identified five names trading at lowest valuations to consensus 2015 earnings estimates, using data supplied by Thomson Reuters Bank Insight. We did not take our analysis out to 2016, as KBW did, because 2016 estimates are not available for the great majority of bank stocks.

Our "stick to the wall" approach limited us to the 105 stocks among 1,101 publicly traded U.S. banks for which consensus 2015 EPS estimate data was available. JPMorgan Chase and Bank of America made our initial "cheapest five" list. JPMorgan was the second-cheapest at Friday's close, with shares trading for 8.8 times the consensus 2015 EPS estimate of $6.43. Bank of America was third, with shares trading for 9.2 times the consensus 2015 EPS estimate of $1.61.

Leaving aside Bank of America and JPMorgan, here are the five U.S. bank stocks trading at lowest valuations to consensus 2015 earnings estimates:

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