Interest rates are rising, loan losses are low, and banks are already proving to be the biggest winners from a corporate tax cut passed last year. But in an industry where companies make money by taking and managing risk, it pays to be selective about which stocks to invest in.
This big bank could have lots of room to climb
Matt Frankel (Bank of America): Even after its massive rally over the last two years or so, I still think Bank of America has lots of room to the upside.
For one, it stands to benefit more than most as interest rates continue to rise. The Federal Reserve currently projects another seven or eight rate hikes by the end of 2020, meaning that interest rates could rise by another 2 percentage points. Bank of America has a higher-than-average concentration of noninterest-bearing deposits, meaning that its lending operations benefit more as rates climb.
In fact, Bank of America has said that a 100-basis-point parallel shift in the interest rate yield curve would result in $3 billion in additional interest income annually.
Additionally, management has been doing a tremendous job of increasing Bank of America's efficiency and profitability. Through strategic branch closures and a big emphasis on cost-saving technologies, Bank of America's efficiency ratio has improved by 3 percentage points over the past year alone, and management has indicated that it intends to keep this efficiency trend going.
Finally, even after the improvements, Bank of America is one of the cheapest banks in the sector, trading for less than 1.3 times book value. For comparison, JPMorgan Chase trades for about 1.7 times book and even troubled Wells Fargo trades for a multiple of almost 1.5.
The bottom line is that Bank of America is still trading like a lower-quality bank stock, although the bank's recent performance tells a different story.
Banking across the pond
Dan Caplinger (UBS): U.S. investors rarely give foreign banks much notice, and frankly, that's been a smart move in many cases in the recent past. Switzerland's UBS is just one of many European financial institutions that has found itself in the crosshairs of regulators for alleged improprieties, including charges of manipulation of the key London interbank offered rate benchmark for short-term interest rates as well as charges of foreign exchange manipulation. That's forced the bank to take swift measures in order to try to restore its reputation and find new avenues for growth.
UBS hasn't shied away from the task. The bank has made sizable investments in upgrading its technology in order to keep up with the pace of innovation in the financial services industry. It's also moved to boost its exposure to the fast-growing Chinese market by seeking permission to take a controlling stake in its UBS Securities joint venture in the emerging-market nation. Overall, the Swiss bank is working hard to restructure itself in an effort to take advantage of the recovering European economy, even as it extends its scope to become even more of a global powerhouse.
Unlike its U.S. counterparts, UBS hasn't already seen a big share-price bump in anticipation of better times ahead. It looks like it's coming, though, and when it does, UBS will be in a good position to take full advantage.
A bank with a hidden gem
Jordan Wathen (Webster Financial Corporation): This Connecticut-based bank struck gold in a niche corner of the banking world. Its HSA Bank division is one of the biggest administrators and depositories of health savings accounts (HSAs), which allow savers to set aside pre-tax cash for future medical bills.
Being the banker for HSAs is incredibly lucrative, since deposits are sticky, interest rates aren't a main selling point, and balances tend to increase over time, as savers put more in their HSA in any given year than they spend on medical expenses. (For perspective, the average account opened at HSA Bank in 2007 was roughly seven times larger than the average account opened in 2016, according to Webster's investor day presentation last year.)
Most importantly, few banks are equipped to compete in this corner of the industry. Given the average account may have only a few thousand dollars in deposits, it's a business where banks have to go big or go home -- scale is the name of the game.
HSA deposits currently make up about 25% of Webster Financial's total deposit mix, but I expect that number to only grow. In the first quarter, Webster reported that HSA deposits increased by 14.5% year over year, far faster than the 3% increase in all other deposits. As this niche business line grows margins should expand, since Webster pays just 0.20% on HSA deposits, a rate that has held steady for years.
Webster Financial's HSA business is everything you want in a bank. It generates recurring fee income, low-cost liabilities, and reliable deposit growth that investors can count on.
Dan Caplinger has no position in any of the stocks mentioned. Jordan Wathen has no position in any of the stocks mentioned. Matthew Frankel owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.