NEW YORK ( TheStreet) -- Following an amazing two-year recovery, where should bank stock investors look for outperformance next year?
The equity analyst team at RBC Capital Markets -- led by Gerard Cassidy -- in a report on Tuesday said the banking industry is in the "late innings of credit improvement," which has been a major driver for stocks over the past several years.
"We believe investors will focus on banks that can generate revenue growth in 2014 versus credit quality improvement in the past two years. However, investment opportunities still exist in companies that are best positioned to capitalize on the strategies that work best for their particular environments," RBC's analysts wrote.
The KBW Bank Index ( I:BKX) has risen 31% this year, following a 30% return during 2012. That compares to a 25% gain for the S&P 500
So which bank stocks are still cheap?
According to data supplied by Thomson Reuters Bank Insight for the 24 components of the KBW Bank Index, throwing in data for Goldman Sachs ( GS), Morgan Stanley ( MS), Discover Financial Services ( DFS) and CIT Group ( CIT), these large banks trade cheapest to tangible book value:
Citigroup's ( C) shares closed at $50.90 Monday and traded for 0.9 times tangible book value. That's the lowest price-to-tangible-book ratio among the 24 components of the KBW Bank Index and the four other large-cap names listed above.
Banks trading for 1.2 times tangible book include Bank of America ( BAC), Zions Bancorporation ( ZION) of Salt Lake City, Goldman Sachs, Morgan Stanley and CIT Group.
Another quick way to identify potential bargains is to look at forward price-to-earnings ratios. Since we're close to the end of 2013, let's push it out an extra year. These banks among the group listed above trade cheapest to consensus 2015 earnings estimates among analysts polled by Thomson Reuters:
Citigroup again is the cheapest, with shares trading for 8.5 times the consensus 2015 EPS estimate of $5.98, based on Monday's closing price of $50.90.
Next is JPMorgan Chase ( JPM), which closed at $56.31 Monday and trades for 8.9 times the consensus 2015 EPS estimate of $6.36.
Third-cheapest on this basis is Bank of America, which trades for 9.6 times the consensus 2015 EPS estimate of $1.59, based on Monday's closing price of $15.24.
That looks like a pattern, since the above systemically important financial institutions are facing higher capital requirements, the implementation of the Volcker Rule, the continuing implementation of other regulations based on the Dodd-Frank bank reform legislation, as well as regulator investigations. But the pattern is broken by two relatively inexpensive credit card lenders, which have been achieving much stronger returns on equity.
Capital One Financial ( COF) closed at $72.18 Monday and trades for 9.7 times the consensus 2015 EPS estimate of $7.43.
Discover trades for 9.9 times the consensus 2015 EPS estimate of $5.08, based on Monday's closing price of $53.72.
Please see Capital One, Discover Are Bargains as Industry Resumes Growth for more on the strong earnings performance of the card lenders.
RBC provided price-to-forward earnings ratios based on the firm's estimates of "normalized earnings," which will reflect a continued decline in credit costs, lower litigation costs and the eventual increase in net interest margins. On this basis, the cheapest bank stock covered by RBC is Popular ( BPOP) of Puerto Rico, trading for 6.4 times normalized earnings.
JPMorgan Chase is next, trading for 7.5 times normalized earnings; followed by Citigroup, at 7.8 times normalized earnings; Bank of America, at 8.2 times normalized earnings and First Horizon National ( FHN) of Memphis, Tenn., at 8.6 times normalized earnings.
The Fed and Net Interest Margins
Investors are expecting long-term interest rates to rise significantly during 2014, as they have done this year, in anticipation of a tapering of the Federal Reserve's "QE3" purchases of long-term U.S. Treasury bonds and agency mortgage-backed securities. The Federal Open Market Committee meets Tuesday and Wednesday, after which outgoing Federal Reserve chairman Ben Bernanke on Wednesday afternoon will discuss at a press conference any change in central bank stimulus policy.
But whether the Fed curtails its bond buying on Wednesday or early in 2014, as most economists expect, banks' net interest margins will still be pressured next year because the federal funds rate -- the central bank's main policy tool -- has been held to a historically low target range of zero to 0.25% since late 2008. Most big banks need to see a parallel rise in interest rates for significant expansion of their net interest margins and increases in net interest income.
RBC estimates all but four of the top 20 U.S. commercial banks will see continued margin contraction during 2014.