Safe Stocks in the Risky Financial Sector

To say that banks have been hit hard over the past year would be an understatement.  The subprime fiasco and ensuing credit crisis claimed many victims ranging from bankruptcy for such stalwart regional mortgage companies like Homebanc (one of the 100 Best Companies to work for in 2007 – oops!) to huge losses for such giant international banks as Citigroup (C), which has lost over 50% of its market value over the last year.  But not all banks are on the verge of bankruptcy like the financial media would lead you to believe.  In particular, there are 2 banks I think offer high long-term returns relative to the risks involved:  Bank of America (BAC) and US Bancorp (USB).

Bank of America

Bank of America is the largest retail bank in the United States, with over 10% of total deposits according to Morningstar, and, if BAC’s acquisition of Countrywide Financial (CFC) goes ahead as planned, BAC will have the lead in every single consumer banking category from savings accounts to mortgages and everything in between.  Even with a slowdown in the housing market and assuming large write-downs related to subprime losses, BAC should be able to keep attracting retail deposits.  But Morningstar asserts, and I agree, that the largest driver in future earnings are likely to be BAC’s Wealth Management division.  Currently, “…only 10% of B of A’s estimated 8 million affluent customers currently avail themselves of its wealth-management products.”  BAC clearly has plenty of room to expand in the wealth management segment, which is quite possibly one of the most profitable lines of business around.  Add that growth potential with an Earnings Yield of over 10% (on artificially depressed earnings, no less) and a dividend yield approaching 6% and you have what appears to be a compelling bargain.  Assuming BAC can conservatively increase earnings at only 5% (basically inflation +1%) per year over the next decade, you’re still looking at a total return in the 10-11% per year range, half of it being cold hard cash.  Morningstar is even more optimistic, predicting returns of close to 30% annually over the next 3 years.

US Bancorp

The case for US Bancorp (USB) is more straightforward.  USB has consistently been among the most profitable US banks in existence, with Returns on Assets topping 2% consistently over the past 5 years and Returns on Equity in the low 20′s with below-average financial leverage.  Furthermore, USB has avoided subprime exposure almost completely to date, minimizing the chance of any significant subprime-related write-downs in the near future.  On the one hand, a prolonged credit crunch could dampen future earnings potential due to the increased difficulty of acquiring financing.  Fortunately, the yield spread between short and long-term debt has been increasing of late which should improve operating margins for all banks.  With a P/E of almost 13 and a dividend yield of 4.3%, USB isn’t the cheapest bank around;  however, it is one of the safest and its consistently high levels of profitability go a long way towards justifying its above-average valuation.  If that’s not enough for you, Warren Buffett just bought shares. There are few people who’s investment judgment I trust, but Buffett’s tacit endorsement means a lot.