Hybrid Bank Stocks Offer Investors Returns With a Twist

Historically, banks are strong participants in any robust U.S. economic recovery.

Banks provide credit -- the lubricant for consumer purchases and business growth. Common shares are a sure-fire way to invest in a positive American story. However, two big banks offer hybrid equity alternatives with interesting features:

  • Wells Fargo Corp (NYSE: WFC  ) warrants
  • U.S. Bancorp (NYSE: USB  ) Series B preferred shares

Made in the U.S.A.
Wells Fargo and U.S. Bancorp focus heavily on U.S. banking operations. Ranked No. 4 and No. 5 by assets, these two companies stick to business right here in the United States. Largely playing outside of overseas markets and arcane trading activities, these banks would have a direct line of sight on an American economic renaissance.

Both institutions have a simple business model: Take in deposits and write residential mortgage, consumer, and business loans. Banking fees associated with these activities provide nearly half of each bank's total revenues.

Conservatively managed, Wells and U.S. Bancorp have enjoyed consistent post-recession earnings growth, credit improvement, and loan book expansion. Yet the common shares appear cheap, trading at a price-to-earnings ratio least 2 or 3 multiple points less than their respective 10-year averages.

Why own Wells Fargo warrants?
In 2010, Wells Fargo issued warrants as part of the Federal T.A.R.P. program. Warrants are securities that act much like long call options; owners have the right, but the not the obligation, to exchange one warrant for one common share of stock at a given price if exercised within a specific time period.  

Wells Fargo warrants currently sell for about $15 each and have an exercise price of $34.01. Wells common stock trades at approximately $43 a share. Therefore, the warrants are about $9 "in the money." The securities are very long-dated: Wells Fargo warrants do not expire until October 2018.

Investors purchasing these warrants generate considerable leverage versus buying the common stock outright. One warrant costs about a third of the price of a common share. This means an investor can control triple the number of shares with the same amount of capital had he bought the common stock. Yet the warrant price moves nearly in tandem with the regular shares. For example, if the stock price rises from $43 to $50 a share, the common stock investor reaps a 16% gain. The warrant owner would see prices increase by $6 or $7 each; an original $15 investment may experience a 40 to 45% jump.

What's the downside?

Warrant holders are ineligible for dividends. In addition, the $6 "in the money" premium per warrant will erode over time, as the price of the warrant plus the $34 strike price will converge upon the common stock price as 2018 approaches. 

On the other hand, if Wells Fargo earnings continue to grind upwards, and the price/earnings multiple returns to its historic norm, the common shares could easily be worth $75 each by the time the warrants expire ($5 EPS times a 15 P/E). 

Such a scenario offers a potential 275% gain in five years.

What's special about U.S. Bancorp Series B preferred?
Preferred stock typically act like a cross between an equity and a bond: Shares are sold on an open market, but a fixed dividend is paid "ahead" of dividends to common shareholders. The result combines a safe dividend (often eligible for preferential 15% tax treatment) with a stock price that doesn't move very much.

Not very sexy.

However, U.S. Bancorp B Series shares have two unusual attributes that add some juice to the mix:

  • The dividend isn't fixed. It "floats" above the LIBOR rate, thereby offering the investor inflation protection.
  • These preferred shares trade at a meaningful discount to "par."

Most preferred stock dividends do not change. However, the floating rate Series B shares link the payout to the 3-month LIBOR (London Inter Bank Overnight Rate) plus 350 basis points. The most recent dividend paid was $0.223 per share. Based upon a closing share price of $19.33, investors realized a stout 4.63% annualized yield. Given historically low interest rates, the payout should eventually move in one direction: up. 

These shares offer another excellent feature: They trade significantly below the stated $25 par value. Therefore, if U.S. Bancorp decides to redeem the securities, holders will receive full par value plus any declared and unpaid dividends. The differential between current price and par is a healthy 29%.

Why is there such a big difference between par and market?  

On September 6 and 9 this year, huge blocks of shares were sold. Volume exploded: 1.1 million and 5.5 million shares were traded versus the normally thin average daily volume under 100 thousand shares. The forced sales drove the share price down from about $20 to a low of $17.29. The stock has drifted since that time.

Nonetheless, the underlying fundamentals of issuer U.S. Bancorp remain as sound as ever.

Opportunistic investors may decide these share offer a safe, generous, and inflation-protected yield, while awaiting a price bounce.

Hunting for value
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