Beating Isn't Good Enough for Banking Giants

Don't let it get away!

Keep track of the stocks that matter to you.

Help yourself with the Fool's FREE and easy new watchlist service today.

You can expect the earnings and stock prices of investment banks and their universal banking cousins to be increasingly volatile over the next several quarters. Yes, JPMorgan Chase (NYSE: JPM  ) , Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Goldman Sachs (NYSE: GS  ) provided us with a string of positive earnings surprises, but this masks creeping risk in the financial system and significant uncertainty regarding banks' earnings power.

On Tuesday, Goldman announced earnings-per-share (EPS) of $2.98, blowing through the analysts' estimate of $2.28. The market cheered, pushing shares up 2%, compared to a 1.6% loss for the S&P 500.

When analysts lower the bar
Hold on a moment. Just what sort of expectations did the firm exceed? Certainly not those that prevailed just 30 days ago, when the consensus estimate was $3.33. Analysts proceeded to slash their estimates by nearly a third in the run-up to the earnings report. By last month's standards, then, Goldman's earnings-per-share (EPS) would have missed their mark by more than 10%.

Here is another puzzle with moving parts: Goldman's largest single cost is its people, with employee compensation typically gobbling up between 40% and 50% of revenue. For the first nine months of 2010, the ratio stands at 43% -- the lowest nine-month figure since Goldman's 1999 IPO. The full-year compensation-to-revenue ratio in 2009 was also exceptionally low, at 36%. However, it's not clear that the credit crisis will result in a permanent reduction of this ratio, or whether this is just a form of temporary appeasement.

The mortgage chickens come home to roost
Meanwhile, B of A was visited by the ghost of questionable underwriting past. After the bank released its earnings Tuesday, Bloomberg reported that PIMCO, BlackRock and the Federal Reserve Bank of New York are among a group of bondholders demanding that B of A repurchase soured mortgages relating to $47 billion of mortgage-backed securities. The story immediately overshadowed any positive sentiment because of the bank's earnings, and the shares lost 4.4% on the day.

B of A's Countrywide Financial unit originally packaged these mortgages into securities that these investors ultimately acquired. The securities contain provisions requiring the originator to repurchase the loans under certain conditions -- if it misrepresented the quality of said loans, for example.

A close-knit group
Where does all this leave these megacap financials? Add Morgan Stanley (NYSE: MS  ) to the four banks mentioned in the first paragraph, and you get five stocks that are very tightly grouped in terms of their price multiple on 2011 earnings, with a range of 8.0 to 9.1. The same is broadly true regarding 2012 earnings multiples. At similar valuations, the obvious trade ought to be the highest-quality franchise. That title, by the way, belongs to Goldman, which also happens to be the only bank in the group with shares trading above book value. (Shares of B of A and Citigroup haven't traded at a premium to book value since October 2008!)

Balance sheet concerns remain
The other shares' discount to book value suggests that the market remains concerned about the possibility of further rot in bank balance sheets. With bond investors now clamoring to return poor-quality mortgages to B of A, investor concern was and is clearly justified.

In the near term, I think large-cap financials -- which led the rally that began in March 2009 -- have lost all claim to market leadership while investors come to grips with two notions: First, because of an extraordinary set of circumstances, 2009 represented a cyclical high for investment bank profits. Second, while the Fed's zero-interest-rate policy is a historic bonanza for the top banks, it is simultaneously introducing new risks into the financial system -- and that's before you even mention quantitative easing, or money printing.

A basket may work better here
Over the longer term, if you think the economy will muddle through, these banks' "normal" earnings power will emerge over the next few years, and they will undoubtedly continue earning economic rents. An alternative strategy to trying to handicap the best stock among them would be to buy the entire basket of five stocks (to which I would be tempted to add Wells Fargo). After all, the credit crisis and various government responses have cemented the investment banking oligopoly and the concentration in assets at the top of the U.S. banking system. For patient investors who are willing to endure some bumps along the way, that basket looks reasonably likely to produce better-than-market returns.

Not all sectors will benefit equally from economic recovery. In a free report, the Motley Fool's best analysts identify 3 ETFs set to soar during the recovery.

Alex Dumortier, CFA has no beneficial interest in any of the stocks in this article.

Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Read/Post Comments (0) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1340074, ~/Articles/ArticleHandler.aspx, 10/27/2016 9:08:13 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,169.68 -29.65 -0.16%
S&P 500 2,133.04 -6.39 -0.30%
NASD 5,215.97 -34.29 -0.65%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/27/2016 4:00 PM
BAC $16.91 Up +0.04 +0.24%
Bank of America CAPS Rating: ****
C $49.93 Down -0.08 -0.16%
Citigroup CAPS Rating: ***
GS $177.75 Up +0.68 +0.38%
Goldman Sachs CAPS Rating: ***
JPM $69.23 Up +0.10 +0.14%
JPMorgan Chase CAPS Rating: ****
MS $33.82 Up +0.43 +1.29%
Morgan Stanley CAPS Rating: ****