Betting on Banks? Look for Regional Rebounds

Betting on Banks? Look for Regional Rebounds

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The third quarter is finally over, and the preliminary data on the revenues that investors can expect investment banks to report from their operations in the last three months are already painting a rather grim picture.

Globally, according to preliminary data from Dealogic, investment banking revenues fell 19 percent in the first nine months of 2012 to $20.3 billion, while on a quarterly basis, the third quarter of 2012 was worse than any three-month period since the first quarter of 2009, immediately after the financial crisis.

That’s not good news for banks, and analysts already are publicly fretting about what it will mean for earnings. JMP Securities reiterated its “sell” recommendation on a cluster of major banks late last month, pointing out that trading has been slow and that the all-important interest rate spread – the gap between the rate at which banks make loans and pay out interest to depositors – remains relatively tight.

Factor in provisions for future losses on bad loans, and the picture might be bleak. Factor in Europe – don’t kid yourself, the famous pledge by ECB honcho Mario Draghi to do “whatever it takes” to rescue the single currency is a lot easier to utter than to make come true – and there are plenty of headwinds out there.

Bank stocks may have rallied in recent weeks, and be outperforming the S&P 500 at present but that doesn’t mean that they are alluring investments.

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Even the asset management arm of Goldman Sachs (GS) isn’t all that crazy about hanging on to many big bank stocks. Indeed, Goldman analysts publicly stated their belief that the slump in profitability – few of the top banks are earning anything approach a respectable return on equity, one that covers the cost of their capital – isn’t due to the cyclical economic downturn, as bank CEOs have repeatedly opined. Instead, they suggest the problem is due to a secular shift in the operating environment for banks, one that features tougher capital rules and more draconian regulatory oversight and regulations.

It’s up to those banks to find a way to spin off underperforming assets that are a drag on returns because of the amount of capital they require. Meanwhile, it’s up to investors to identify banks that are in a better position from the point of view of their balance sheet or capital position, or because they have other benefits.

If you’re still interested in keeping financial stocks in your portfolio, whether as a way to play (indirectly) the growth in the housing market, QE3 or a steepening yield curve, then it might make sense to take another look at regional banks.

True, some analysts aren’t all that enamored of this group, either. In mid-September, Bernstein Research analysts cut their outlook for the shares of SunTrust Banks (STI), BB&T Corp. (BBT) and Huntington Bancshares (HBAN) to market perform, arguing that their recent “strong outperformance” means that there are fewer “compelling values” amongst the ranks of the regional banks. “We see no near-term positive from (interest) rates, and we believe real estate strength has been priced in." True, these companies have been amongst the group’s leaders of late, and have posted significant gains.

But just because these banks have done well doesn’t mean they can’t do still better – especially on a relative basis, for investors who want to keep financials in their portfolio but who are wary of the myriad headwinds confronting the massive money-center banks.

Regional banks, by definition, have one big advantage: They offer investors a way to invest in a specific region of the country, one that may be seeing more solid economic growth, a healthier job market and less of a hangover in the shape of unsold homes and underwater mortgages that will weigh on a bank’s ability to issue new loans and limit its loan loss provisions. If you want to make a bet on the mid-Atlantic region down to the Southeast, think about Regions Financial (RF). It trades at a discount to many of its peers, thanks in part to the fact that it was among the last banks to repay bailout funds. But Goldman Sachs analysts just boosted their rating on the bank to a “conviction buy” from a mere “buy” because of the potential value that could be unlocked if it restructures its operations. Awaiting that, there is plenty of upside ahead as the bank’s credit portfolio improves in quality and investors recognize its relatively healthy balance sheet, analysts argue.

Depending on who you ask, you’ll get different views on which regional bank stock is the best to own, but a few names keep coming up repeatedly: PNC Financial Services (PNC), which offers a 2.54 percent yield; Fifth Third Bancorp (FITB), which gives investors exposure to the Midwest, where execs say they are seeing gains in mortgage banking and grabbing market share, and KeyCorp (KEY), which offers exposure to Denver, has cut its costs and seen net interest margins improve, are just a few of them. Credit Suisse analysts announced in mid-September that they have seen more bullish comments regarding lending activity than they had expected from a number of regionals, including BB&T, Huntington and Fifth Third but also Comerica (CMA), TCF Financial (TCB) and Zions Bancorp (ZION).

Don’t expect bank stock investing to be straightforward, even if you favor some of these large or mid-sized regional players: big enough to be powerful, but not so big that they are buffeted by exposure to global crises. True, they are able to shelter from the European storm and what happens in the Midwest or Southeast is likely to have more impact on their bottom line than whether Chinese GDP grows at 5 percent or 8 percent this year.

But they all are less reliant on volatile and increasingly costly investment banking and trading operations as a source of revenues and profits – and that’s likely to be good news for now. For the most part, their names have also remained less tainted by the banking catastrophe of 2007 to 2009; while most of them accepted TARP money to stay afloat, and many were issuing subprime mortgages, they weren’t viewed by the public or by legislators as being as responsible as the behemoths like Citigroup (C) or the mortgage players like Countrywide for the debacle.

If you want to include financials in your portfolio – whether in the interest of balance or in hopes of profiting from QE3 or a further uptick in mortgage lending – this may still be the first place to look for candidates.