Why banks beat bonds

(Fortune Magazine) -- Wouldn't it be great if you could find the ideal blend - an investment that combined the cozy security of government bonds with the double-digit returns investors expect from stocks? That seems like a pipe dream in a world where ten-year Treasuries yield 5 percent and equities sell at premium prices that augur a dim future.

But this ideal investment exists, and believe it or not, it's called a bank stock. Hold that yawn. Bank stocks offer a sterling array of qualities right now. They pay huge dividends, approaching 5 percent, that are bound to keep rising. They're incredibly cheap. And their prospects for growth are surprisingly sprightly.

Three giant banks with beaten-down share prices and fat dividend yields are excellent choices right now: Bank of America (Charts, Fortune 500), Citigroup (Charts, Fortune 500) and Wachovia (Charts, Fortune 500). To grasp what makes them good buys, it's important to understand their voluptuous profitability. These banks need to invest less than a quarter of their immense earnings in new branches, deposit systems and trading programs to sustain their modest but highly consistent growth. They return the vast bulk of their profits to shareholders via dividends and stock buybacks. Today BofA yields 4.5 percent, while Citi and Wachovia pay around 4.3 percent. After the 15 percent tax on dividends, investors pocket more than they do from ten-year Treasuries, which yield 5 percent but face a 35 percent top federal levy.

It gets better. Dividends are likely to keep growing. BofA, for example, is expected to raise its payout about 11 percent in July, bringing the yield to an extraordinary 5.1 percent. Look for the other banks to announce major hikes this year to close in on the 5 percent mark.

How do you get from that yield to the holy grail, a total return of more than 10 percent? The extra juice comes from earnings growth. Over the long term, the banks figure to raise earnings an average of at least 6 percent a year. They are also buying back around 2 percent of their shares annually.

In 2006 and 2007, BofA is expected to spend around $8 billion on buybacks; at Wachovia the figure tops $5 billion. Hence, earnings per share should grow, on average, about 8 percent annually. If P/E multiples don't drop, share prices should jog forward at around that rate, bringing total returns - stock gain plus dividends - to a sumptuous 12 percent to 13 percent.

Sounds too good to be true - and that's what the market thinks, which is why the stocks are cheap. But this is a case where the market seems to be wrong. "Investors fear a credit meltdown because of the woes in subprime," says Betsy Graseck, an analyst with Morgan Stanley. "That's making the market far too pessimistic about bank stocks." Not one of these banks has troubling exposure to subprime credit, since they sell almost all such loans to institutional investors.

Right now the outlook for profits at the three banks runs the gamut from robust to sluggish. None of them face the outright stagnation the market fears. Surprisingly, the fastest grower is now Citi. After years of struggling with regulatory issues, America's biggest financial institution is finally investing heavily in its principal asset: its huge global franchise. It's also pledging to cut its bloated overhead $4.6 billion a year by 2009. "Citi's expected growth is unusually high because it's on an efficiency drive," says Graseck. Result: Citi's earnings per share are on track to rise about 7 percent in 2007 and post a double-digit gain in 2008.

Wachovia has shrewdly invested in fast-growing sectors, notably brokerage, through its joint venture with Prudential and pending $6.8 billion acquisition of A.G. Edwards. Right now its growth is hurt by a slowdown in originations at its Golden West subsidiary in California. This year earnings per share are expected to rise only around 6 percent. But Graseck projects 8 percent gains starting in 2008 as Wachovia capitalizes on its growing footprint in California and the Southwest.

Bank of America, which boasts the biggest U.S. consumer franchise, with almost 6,000 branches, is suffering most from the flat yield curve that prevents banks from making big, easy profits the old-fashioned way, by borrowing at low short-term rates and lending on fixed mortgages and student loans at far higher rates. The market also fears that CEO Ken Lewis will make an expensive overseas acquisition. That's a real concern. But with its strong nationwide brand and power in the fast-growing Hispanic markets, BofA packs far more earnings power than the market projects.

Best of all, the banks boast mouthwatering P/E multiples, giving value investors what they prize most: plenty of margin for error. Today Citi, Wachovia and BofA trade for an average of just 11 times the previous 12 months' earnings. That's far below the S&P 500's P/E of 18.3, and the mid to high teens for big dividend payers like drugmakers and telecoms. The risk that their P/Es will fall is minuscule. It's far more likely that they'll rise as investors gain new confidence in their enduring earnings power. At these prices the boring become beautiful.