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Smaller Regional Banks Are in a Sweet Spot

NEW YORK ( TheStreet) -- Investors are showing a clear preference for stocks of relatively small regional banks and KBW analyst Frederick Cannon expects this trend to continue.

Looking at current stock valuations to tangible book value and to consensus earnings estimates for 2014 and 2015, the largest U.S. banks are trading at very significant discounts to their smaller competitors:

  • Shares of JPMorgan Chase (JPM - Get Report) closed at $57.70 Friday and traded for 1.6 times tangible book value, according to Thomson Reuters Bank Insight.  The shares trade for 9.6 times the consensus 2014 earnings estimate of $6.00 a share, according to Thomson Reuters, and for 9.1 times the consensus 2015 EPS estimate of $6.35.
  • Bank of America (BAC) closed at $15.60 Friday. The shares trade for 1.2 times tangible book value, for 11.8 times the consensus 2014 EPS estimate of $1.32, and for 9.8 times the consensus 2015 EPS estimate of $1.59.
  • Citigroup (C) closed at $52.21 Friday. The shares trade for 1.0 times tangible book value, for 9.8 times the consensus 2014 EPS estimate of $5.34, and for 8.8 times the consensus 2015 EPS estimate of $5.96.
  • Wells Fargo (WFC - Get Report) closed at $44.96 Friday. The shares trade for 2.2 times tangible book value, for 11.2 times the consensus 2014 EPS estimate of $4.01, and for 10.6 times the consensus 2015 EPS estimate of $4.23.
The average current price-to-tangible-book (P/TBV) for the "big four" is 1.5, while the group on average trades for 10.6 times consensus 2014 EPS estimates and 9.6 times consensus 2015 EPS estimates.  Wells Fargo consistently trades at a higher P/TBV than the rest of the big four, in part because it consistently out-earns its largest competitors.  The company's return on tangible common equity (ROTCE) for the first three quarters of 2013 was 17.86%, compared to respective returns of 11.59% for JPMorgan Chase, 7.44% for Bank of America and 8.95% for Citigroup.

Of course, JPMorgan's year-to-date numbers are skewed by the company's third-quarter net loss, caused by $9.15 billion in provisions for litigation reserves, before tax.  But Wells Fargo consistently outperformed JPMorgan, Bank of America and Citigroup during the previous three years.  Wells Fargo also seems to have a smaller regulatory target on its back than JPM and BAC.

Regardless of the solid prospects for Wells Fargo and JPMorgan, assuming 2014 is a whole lot less painful for JPMorgan than 2013 has been, investors are wary of the big four because of the radical transformation the group is facing. Threats to investor returns include higher capital requirements, annual stress tests and capital plan reviews by the Federal Reserve, the Volcker Rule's ban on proprietary trading, higher liquidity requirements and, of course, the endless flow of actions against the banks -- and their shareholders, not their executives -- by regulators, the Department of Justice and states' attorneys general for mortgage loan and securities sales through 2007, as well as investigations into foreign exchange manipulation, the LIBOR scandal, etc.

Looking past the big four, U.S. regional banks and trust/custody banks with total assets of over $100 billion trade for an average of 2.1 times tangible book value 12.2 times consensus 2014 EPS estimates and 11.1 times consensus 2013 EPS estimates.

"Premium valuations for [small-cap and mid-cap] banks will create regional and industry champions in the $20 billion to $35 billion asset range over the next five years," according to Cannon.

Investors agree, based on current stock valuations.  U.S. banks with total assets in that range trade for an average of 2.0 times tangible book value, for 17.0 times consensus 2014 EPS estimates and for 15.3 times consensus 2015 estimates.

Cannon in a note to investors on Sunday wrote "These banks will use their premium valuations to acquire and merge with competitors and pick up lending teams from larger competitors. They will become the preferred banks to work at and be clients of, in our view."

Banks of this size tend to be better prepared than the largest banks to enable their commercial lenders to maintain strong local relationships with business borrowers, which also tend to bring other key business to the banks, including checking deposits and cash management services.  PrivateBancorp (PVTB) of Chicago is a prime example of a local bank benefiting from the "poaching" of commercial loan officers from a huge bank -- in this case, Bank of America -- that purchased a major local competitor many years back.

Cannon did acknowledge that investors could still be looking at bargains among the largest banks, even after a very strong recovery for the stocks over the past two years, because of the low valuations, and because "earnings at large banks, while lower relative to book value then they were historically relative to small banks, are arguably safer than in the past due to higher levels of capital."

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