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) - Get Report 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) - Get Report 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."
He added that "A safer earnings stream [for the biggest banks], all things being equal, should receive a higher valuation."
But the analyst wrote that "growth is constrained by regulation at the large banks, which should limit their relative P/E multiple. Overall, we expect the SMID bank premium multiple to be sustained."
OK, so what should long-term investors, who can ride this wave for the next five years, be considering?
Rather than focus on banks currently within the sweet spot of $20 billion to $35 billion in total assets, Cannon listed 14 names that KBW expects to grow sufficiently to be considered "regional and industry champions" over the next five years. The names on this list on average trade for P/TBV of 2.5, for 17.9 times consensus 2014 EPS estimates and 14.5 times consensus 2015 EPS estimates. KBW has neutral "market perform" ratings on half the group, with six rated "outperform" and one rated "underperform."
Here are two fast-growing names included in KBW's list that are already quite familiar to may bank stock investors, and were among the banks showing the best loan growth during the third quarter. Both are rated "market perform" by KBW:
- First Republic Bank (FRC) - Get Report of San Francisco. The bank had $41 billion in total assets as of Sept. 30, exceeding the ideal range cited by Cannon. The shares trade for 2.4 times tangible book value, for 16.7 times the consensus 2014 EPS estimate of $3.11 and for 15.2 times the consensus 2015 EPS estimate of $3.42. First Republic reported 18% year-over-year growth in average loans. Its ROTCE for the first three quarters of 2013 was 15.77%.
- Signature Bank (SBNY) - Get Report of New York. The bank had $21 billion in total assets as of Sept. 30. The shares closed at $107.87 Friday and traded for 2.9 times tangible book value, for 20.2 times the consensus 2014 EPS estimate of $5.34, and for 17.8 times the consensus 2015 EPS estimate of $6.07. The bank has made a major push to expand its equipment leasing business and reported 40% year-over-year growth in average commercial loans and leases through the third quarter. Signature Bank's ROTCE for the first three quarters of 2013 was 12.46%.
Here are the remaining five "market perform" rated names on KBW's list of 14 smaller regional banks that could hit the sweet spot over the next five years:
- City National Corp. (CYN) of Los Angeles.
- FirstMerit (FMER) of AKron, Ohio.
- Prosperity Bancshares of (PB) - Get Report Houston.
- Texas Capital Bancshares (TCBI) - Get Report of Dallas.
- Umpqua Holdings (UMPQ) - Get Report of Portland, Ore.
Here are the six potential "regional and industry champtions" listed by KBW and rated "outperform" by the firm:
- BankUnited (BKU) - Get Report of Miami Lakes, Fla.
- Columbia Banking System (COLB) - Get Report of Tacoma, Wash.
- East West Bancorp (EWBC) - Get Report of Pasadena, Calif.
- PacWest Bancorp (PACW) - Get Report of Los Angeles
- First Financial Holdings (SCBT) of Columbia, S.C.
- SVB Financial Group (SIVB) - Get Report of Santa Clara, Calif.
The one name on the KBW list rated "underperform" by the firm is
of San Antonio. The rating reflects a premium valuation for the shares, which in turn reflects the company's very long and very consistent track record of strong earnings performance, with no surprises. The bank was one of the strongest industry earners for the 10-year period through 2012,
Cullen/Frost had $23.5 billion in total assets as of Sept. 20. The company's ROTCE for the first three quarters of 2013 was 13.02%. The shares closed at $72.93 Friday and traded for 2.4 time tangible book value, for 17.9 times the consensus 2014 EPS estimate of $4.07, and for 17.1 times the consensus 2015 EPS estimate of $4.25.
The following chart shows Cullen/Frost's stock performance this year, against the KBW Bank Index and the S&P 500:
Interested in more on Cullen/Frost Bankers? See TheStreet Ratings' report card for this stock.
Fannie Mae, Freddie Mac Incoming Regulator Signals Policy Shift
Morgan Stanley Sells Oil Merchanting Unit to Russia's Rosneft
Northern Trust Leads Banks on 'GDP Day'
Why Dimon and Blankfein Should Envy Mikhail Khodorkovsky
Share of Cash Home Sales Jumps to 42% in November
Two Bank Stock Picks for 2014, 'Year of the Regulator'
So You Didn't Win the Lottery with J.G. Wentworth
Deutsche Bank Settles with Fannie and Freddie for $1.9 Billion
Target Data Breach Should Not Affect Big Card Processors, Says KBW
-- Written by Philip van Doorn in Jupiter, Fla.
>Contact by Email.
Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.