The Fed’s Christmas Gift to Banks

Bank stocks were hit hard during the market selloff earlier this year. Investors fled the sector over concerns about rising unemployment and a deep economic recession caused by the global pandemic. Despite a broad market recovery since March, banks continue to trade well below the highs reached before the pandemic.

In March, we published a blog piece  in which we explained why we thought investors’ concerns with respect to banks were misplaced. In a nutshell, we argued that underwriting standards, regulatory and capital requirements, liquidity, and earnings power were markedly better than during the 2008-2009 financial crisis. Consequently, we expected the banks to weather this storm well.

On Friday, the Federal Reserve Bank published the second round of stress tests, which evaluated the major banks’ ability to withstand the economic consequences of the pandemic. Like in the first round earlier this year, all participant banks passed the test with flying colors.

The Fed concluded the stress test results with the following statement that validated the way we thought about the sector: “The banking system has been a source of strength during the past year and today’s stress test results confirm that large banks could continue to lend to households and businesses even during a sharply adverse future turn in the economy”. While this conclusion isn’t a surprise to us, we think the stock market is still skeptical — Wells Fargo and Citigroup continue to trade well below their book value, a valuation that would be more appropriate for banks in financial distress but not for viable franchises that should earn returns well above their costs of capital over a full cycle.

Prior to the pandemic, banks had been returning over 100% of earnings to shareholders in the form of dividends and stock buybacks. These actions have been a major source of investment returns for shareholders over the years. Restarting buybacks is the first step of restoring these returns to owners. Buybacks could serve as a catalyst for unlocking the value we see in the banks we own. And buying back any stock at a discount to its true value is accretive to shareholder value. Christmas came early this year for our banks.

If you’re interested in learning more about our philosophy, contact us today.

From the entire team at Summitry, we’d like to wish you and your family a happy holiday season!