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Bank stocks cope best with interest rates

Richard Loth

Standard & Poor’s respected investment research publication, “The Outlook,” recently looked at 20 bank stock, which carry four and five stars (its highest rankings) in their rating list and that it feels are best positioned to cope with rising interest rates.The key factor that favors the stocks of these banks, says S&P, is their relatively high level of “solid fee income.” The banks selected “garner more than 25 percent of their revenues from fees.” Before we discuss the details of S&P’s recommendations, some background information is in order. Interest environmentThere’s little doubt that interest rates are going up. Conventional wisdom, which often isn’t very smart, tells us that bank stocks lose value in such an environment. Sure enough, the market has reacted predictably to the Fed’s recent rate hikes. Bank stocks, in general, have moved to lower price levels during the year.Supposedly, the higher cost of money puts a squeeze on a bank’s net interest income – what banks have to pay to depositors goes up faster than what they can charge borrowers for loans. That might have been somewhat true historically, but today banks have loans that can be re-priced at higher rates more quickly than deposits. In effect, this allows banks to improve net interest margins.And, most importantly, fee income – the principal focus of the S&P study – accounts for substantially more revenue than in the past and is immune to interest movements, up or down. This circumstance has a very positive impact on overall revenue. A new approachMore sophisticated interest rate management and fees have made banks more profitable. Also, banks experience stronger loan demand in an improving economy, which translates into better credit quality (fewer loan losses) and higher returns. The combination of adjustable loan rates and higher than average fee income positions a bank to generate good profits in any interest rate environment.Associated Press business writer Meg Richards cited this phenomenon by observing that “sweeping changes in the industry make banks larger, more diverse and more sophisticated at managing interest rate fluctuations.” This relatively new operational configuration boosts bank profits.Best of S&PI’ve tweaked S&P’s list of 20 favored bank stocks to come up with four really solid choices. First, I eliminated those banks with a current dividend yield below 3 percent. Second, those bank stocks with a P/E ratio above 15 – 12 to 15 is a traditional gauge for banks – were dropped. Next, fee income as a percentage of total revenue (net interest income + fee income) had to be over 40 percent – considerably above S&P’s 25 percent mark. Lastly, I looked for an efficiency ratio (operational expenses as a percentage of revenue lower is better) than the banking industry average of 60 percent. And the winners are: Bank of America (BAC), Citigroup (C), National City Corp (NCC) and US Bancorp (USB). Their respective credentials (P/E ratio, dividend yield, fee income percentage, and efficiency ratio) are: — BAC: 11.9, 4.10%, 43%, and 52% — C: 11.3, 3.50%, 48%, and 56%– NCC: 10.5, 3.80%, 45%, and 52% — USB: 13.2, 3.30%, 41%, and 46% In what some in the investment community consider an overvalued market, this foursome evidences some very reasonable valuations. Their current dividend yields are well over the average, they enjoy significant revenue protection with their high levels of fee income and they are cost-conscious operators. While there are additional investment qualities to consider when analyzing bank stocks, the positive attributes of these banks – and others with similarly strong credentials – are definitely worth considering for individual investor portfolios.The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing, an independent registered investment adviser. Loth can be reached at 827-5591 or mentorinvesting@comcast.net.Vail, Colorado


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