Why bank stocks are cash machines
With their high yields and low P/Es, they offer the potential for solid long-term gains with little risk.
By Shawn Tully, FORTUNE senior writer

(FORTUNE Magazine) - In a world that's buzzing over the Internet's raging return and the dollar play in Asian equities, it's hard to believe that the best place to invest may well be bank stocks.

Try not to yawn. Bank stocks aren't boring, they just look that way. You might say they're so colorless they're colorful. Why? Because what they lack in glamour they more than make up in compelling numbers.

Numbers you can take to the bank...
Four of the Big Five offer compelling stats; with J.P. Morgan, you're betting on a turnaround.
Stocks P/E ratio Return on equity Yield Rate of dividend increase 
Bank of America 12.2 16% 4.0% 14% 
Citigroup 10.0 18% 3.9% 31% 
J.P. Morgan Chase 17.0 8% 3.0% 
Wachovia 12.8 14% 3.7% 19% 
Wells Fargo 14.6 20% 3.1% 19% 
 Notes: Data are as of May 10. Price/earnings ratios are based on past 12 months' earnings. Dividend increases are average annual rate for 2001 through 2005.
 Source: Yahoo! Finance, company Web sites
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The story comes in two parts. First, the biggest banks, from Citigroup (Research) to Wachovia (Research), are paying rich dividends and are likely to increase them steadily, practically guaranteeing double-digit returns far into the future. Second, regional banks and thrifts are prime takeover candidates as the giants rush to expand - witness Wachovia's $26 billion deal for Golden West Financial (Research).

Says Goldman Sachs (Research) analyst Lori Appelbaum: "Bank stocks don't look sexy until you look at the potential returns."

For investors, the big diversified banks offer a rare combination: juicy yields plus significant earnings growth. And even though big-bank stocks are up 7 percent this year, they still sell at bargain prices.

It's a neat package. The five largest U.S. banks are Citi, Bank of America (Research), J.P. Morgan Chase (Research), Wachovia, and Wells Fargo (Research). For the moment we'll set J.P. Morgan aside, because it's the one huge bank that's not yet highly profitable (though it's getting there). The four remaining players boast an average dividend yield of 3.6 percent. That's twice the yield of the S&P and not too far behind the three-year Treasury yield of 4.9 percent.

And while interest rates are just as likely to fall as to rise, the beauty of dividends is that they tend to keep growing. Since dividends are paid from earnings, they typically increase in step with profits. Over the past four years the big banks (again, excluding J.P. Morgan) have raised earnings at double-digit rates.

Result: BofA's dividend has jumped 14 percent a year since 2001, while Wells' has posted annual increases of 19 percent.

But wait - there's more! Let's take a cautious stance. We'll project that the big banks' earnings growth averages to 8 percent over the next seven years, far below the recent level. So dividends should also grow at 8 percent.

The banks, though, offer an added treat. While paying out around 46 percent of their annual profits in dividends, they're typically using another 20 percent or so of their earnings to buy back stock. It's a safe bet that they'll keep buying back about 1.5 percent of their shares annually. Since both earnings and dividends will be spread across fewer shares each year, the dividends per share will rise not by 8 percent a year, but by more like 9.5 percent.

By the way, these numbers tell a powerful story about banking. The banks are using two-thirds of their profits to pay dividends and buy back stock, which means they're retaining only one-third to invest in growing their business. But that's all they need, because banks generate huge returns, both on the capital they already have and on the new money flowing in as retained earnings.

The proof: On average, the four most profitable big banks boast a sumptuous return on equity of 16.5 percent over the past five years, vs. an average of 12 percent for stocks in the S&P 500.

The payoff

Now let's get back to the payoff for investors. You're starting with a 3.6 percent dividend. It's rising at almost 10 percent a year. Those increases should far outstrip inflation. So in 2012, you'll be receiving 6.8 percent, not 3.6 percent, on your original investment, and the payouts will ratchet upward from there.

But wait - there's even more! The dividend payments are just part of your return. If earnings per share keep rising at 9.5 percent annually, the banks' stock prices will increase at the same rate (assuming the relatively low price/earnings multiples remain constant). Your returns should start in the 13 percent range - the 3.5 percent current dividend plus a 9.5 percent capital gain. But in seven years, thanks to the ever-growing dividend, that number should surpass 15 percent.

J.P. Morgan has the potential to deliver even greater returns. To buy the stock now, you have to believe that new CEO Jamie Dimon will be able to turn the bank around (and we do - see "The Contender"). If that comeback happens, the dividend - and the stock price - could soar.

Unlike its big rivals, J.P. Morgan hasn't increased its dividend in five years, chiefly because it's been saddled with weak earnings. Dimon has been expanding in lucrative areas like credit cards and energy and mortgage-backed security trading to increase profitability. If those moves manage to raise J.P. Morgan's ROE from 8 percent to its peers' 16.5 percent average, the dividend will double along with earnings, giving investors who got in early an enormous yield of around 6 percent as well as a big capital gain.

The risks

Is there any risk in these equations? Of course. J.P. Morgan's comeback could stall, and the other banks' share prices could flatten or drop, saddling investors with little more than the single-digit returns provided by dividends. That's possible, but unlikely.

The reason: Bank stocks still look cheap. On average, Citi, BofA, Wells, and Wachovia have P/Es of just 12.4. That's far lower than the multiples in the other big-dividend-paying sectors - pharmaceuticals, utilities, and telecom - even though the banks' earnings are growing just as fast as profits in those three industries. In fact, it's more probable that banking multiples will rise to the 15 or so that prevails in the other big-dividend sectors, adding a big kicker for shareholders.

Investors can play the banking market a second way, by predicting which regional and smaller banks and thrifts the big boys are likely to buy. Today retail banking is highly fragmented: The big five control just 28 percent of nationwide deposits.

"We'll see tremendous consolidation in the industry in the next few years," says Meredith Whitney, an analyst with CIBC World Markets.

The key is geography. Several of the giants have gaps in their footprints. J.P. Morgan and Citi, for example, need to establish big footholds in Florida and California, while Wachovia covets more branches in the West.

Among the best candidates: SunTrust (Research), which is a powerhouse in Florida and Georgia, where Citi and J.P. Morgan need to grow. PNC (Research) is a major player in Pennsylvania and New Jersey, which are among the nation's wealthiest markets. U.S. Bancorp (Research) boasts a solid franchise in the Pacific Northwest, California, and Colorado. Washington Mutual (Research) would hand a buyer 2,200 branches across the country, including a strong presence in California.

Watch the banks. As a famous bank robber put it, that's where the money is.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.