{"id":91291,"date":"2016-06-14T09:25:16","date_gmt":"2016-06-14T13:25:16","guid":{"rendered":"http:\/\/countingpips.com\/?p=91291"},"modified":"2016-06-14T07:25:42","modified_gmt":"2016-06-14T11:25:42","slug":"hunting-for-income-among-bank-stocks","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex\/2016\/06\/hunting-for-income-among-bank-stocks\/","title":{"rendered":"Hunting for Income Among Bank Stocks"},"content":{"rendered":"
June 14, 2016<\/div>
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By WallStreetDaily.com<\/u><\/a> \"Hunting<\/p>\n

As I mentioned last week, with danger lurking among energy master limited partnerships<\/a> (MLPs) and real estate, income investors are increasingly looking elsewhere. And that includes a tried-and-true dividend generator \u2013 the banking sector.<\/p>\n

But beware: Not all of them represent good income investments.<\/p>\n

Large banks are now over-regulated and could be caught up in an international crisis.<\/p>\n

Meanwhile, small- and medium-sized banks face some headwinds.<\/p>\n

For example, credit scoring, risk management, asset and liability management, and other banking essentials all require a substantial investment in IT systems and the people who manage them. And those investments aren\u2019t cheap, putting a dent in smaller banks\u2019 smaller profits.<\/p>

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Furthermore, local banks are subject to the vagaries of that particular locality. The bankruptcy of a single large employer can cause credit difficulties among that employer\u2019s staff, as well as its suppliers and service providers.<\/p>\n

However, for larger banks, the economies of scale aren\u2019t there. They tend to involve themselves in investment banking business, which involves a level of risk management that many banks have failed to master. Just look at JP Morgan Chase & Co.\u2019s<\/strong> (JPM<\/a>) losses in 2012 on the \u201cLondon Whale\u201d trading business.<\/p>\n

The standard benchmark for bank profitability used to be a 10% return on equity. Nowadays, regulators usually force banks to hold more equity than before, reducing returns.<\/p>\n

With long-term interest rates around 2%, a 10% \u201churdle\u201d rate is now far too high. And it implies an equity risk premium of 8% rather than the historically normal 4% to 5%. So if you benchmark banks at a 7% return on equity, some bank stocks are undervalued.<\/p>\n

You want a nice cushion in a bank\u2019s earnings to ensure that when problems arise, the bank doesn\u2019t fall into trouble.<\/p>\n

The Top Contenders<\/h2>\n

As income investors, we\u2019re interested in a high dividend yield. Accordingly, I\u2019ve looked at all the banks with a dividend yield of 4% or more.<\/p>\n

Many such banks have very low returns on capital. Indeed, some pay dividends in excess of net income. So I\u2019ve further limited our search to banks with a net return on equity of 7% or more.<\/p>\n

Surprisingly, this rules out more than half of the high-dividend banks, indicating that the sector is failing to earn an adequate return.<\/p>\n

Some of the largest banks also tend to repurchase shares, further limiting our options. This is a shareholder-hostile tactic in an industrial company, and even more so at a bank, where adequate capital in a recession is the key to survival.<\/p>\n

The two highest yields on U.S. bank stocks are foreign behemoths HSBC Holdings Plc<\/strong> (HSBC<\/a>) and Lloyds Banking Group Plc<\/strong> (LYG<\/a>), both of which yield more than 5%.<\/p>\n

However, Lloyds\u2019 return on capital is a measly 1%, while HSBC Holdings has a return on capital that only just meets our 7% criterion. Given the additional risk of holding these foreign behemoths, I suggest passing on them.<\/p>\n

The highest dividend available on a bank that meets our criteria is the 4.8% from PacWest Bancorp <\/strong>(PACW<\/a>). PacWest is based in California, where it has 80 branches. It also has one branch in North Carolina.<\/p>\n

It has a return on equity of 7.9% and assets of $21 billion. Its $0.50 quarterly dividend is covered about 1.4 times by earnings, and it\u2019s trading at a reasonable 1.1 times book value and 14.7 times earnings.<\/p>\n

There are three other banks with dividend yields above 4% and returns on capital above 7% that also appear potentially attractive:<\/p>\n