In early 2019, we wrote about the U.S. banking industry’s record of creating wealth for long-term investors. More specifically, we explored a primary driver of this return: U.S. banks’ compounding of book value—a function of the industry’s return on equity (ROE)—coupled with dividends paid to shareholders.
As we return to this topic a year later, it’s clear that bank stocks lost some luster with investors in 2019 as interest rates fell and the yield curve flattened. This pessimism was most pronounced in August, when the yield curve eventually inverted due to concerns over future economic growth. Since then, some concerns related to the economy have dissipated, and the yield curve steepened late in the year. While bank stocks recovered along with the rest of the market, they remain attractively valued in our view, as they currently trade below historical and relative norms, and the fundamentals of U.S. banks’ financial health remain solid. In fact, the headwind that the industry had faced last year from three interest-rate cuts by the U.S. Federal Reserve (Fed) began to fade entering 2020.
Book value, ROE, and dividends
Over the course of 2019, the wealth creation engine for banks kept running, as book value continued to compound. Book value is one of the most important measures of valuation available to investors; it offers a view of the worth of a company’s net assets—what the company’s shareholders would receive today if all the company’s assets were sold and liabilities repaid. The compounding of book value, by extension, maps the trajectory of a company’s or industry’s ability to create shareholder wealth over time. The primary source of compounding book value is ROE, which indicates how much profit a company generates as a percentage of equity. A bank with higher ROE will compound book value at a faster pace.
In last year’s article, we highlighted examples of two banks, U.S. Bancorp (USB) and Hancock Whitney (HWC), to demonstrate their history of compounding book value coupled with their growth in dividend payments. We revisit how these two banks have compounded book value and continued their dividend payments in 2019. Through the end of the fourth quarter, USB’s book value was up 7.0% relative to the end of 2018, while HWC’s was up 10.0%. Additionally, the banks have healthy dividend yields of 3.1% for USB and 2.7% for HWC, further rewarding investors.1
A positive outlook for bank stocks
Industry fundamentals remain strong in early 2020, and we believe banks will continue to compound book value and increase dividends. Several factors inform our view. With the Fed now on pause regarding interest-rate movements, we expect net interest margins—a measure of a bank’s yield on interest-earning assets—to stabilize in 2020 as banks continue to cut deposit rates. We also expect loan growth to continue in the mid-single-digit levels, driven by U.S. real GDP expanding at an annual rate of around 2.0%.
We expect these trends will lead to yet another year of revenue growth for the industry. Additionally, with management teams focused on leveraging technology investments to become more efficient, the industry should produce positive operating leverage. We expect credit costs will remain benign as the economy continues to expand. Finally, we expect banks to continue generating capital returns in the form of ongoing share buybacks and rising dividends. As a result, we believe U.S. banks are likely to deliver earnings-per-share growth in the low- to mid-single digits in 2020 and upper single digits in 2021.
When we look at valuations, the overall industry continues to trade at attractive levels. The sector ended the year trading at 1.35X price/book ratio compared with a long-term average of 1.79X.2 Additionally, from a price-to-earnings ratio perspective, banks trade at 11.3X compared to 20.9X for the broader market.3 Taking into account the potential benefits of compounding book value and growth in earnings, coupled with attractive valuations, we believe this combination provides a favorable entry point for investors.
1 Bloomberg, Inc., as of 2/1/20. 2 SNL U.S. Bank Index, FactSet, as of 12/31/19, based on last 12 months price-to-book value. The SNL U.S. Bank Index comprises all major exchange banks in SNL Financial’s coverage universe. 3 S&P Composite 1500 Banks Index compared with the S&P Composite 1500 Index, FactSet, as of 12/31/19, based on last 12 months price-to-earnings. The S&P Composite 1500 Banks Index tracks the performance of publicly traded large- and mid-cap banking companies in the United States. The S&P Composite 1500 Index tracks the performance of 1,500 publicly traded large-, mid-, and small-cap companies in the United States. It is not possible to invest directly in an index.