The Federal Reserve recently released the results of 2020 bank stress tests, and while no banks are in serious danger, some would see capital levels fall a bit too low for comfort in a prolonged and deep COVID-19 recession. As a result, the Fed issued a formula to govern bank dividends, and there's a real chance bank investors could see dividend cuts from some major financial institutions.
In this episode of Industry Focus: Financials, host Jason Moser and Fool.com contributor Matt Frankel, CFP, discuss the news and what it could mean for bank investors. Plus, Moser and Frankel answer a listener's excellent question on position size and share why they're watching Wells Fargo (NYSE:WFC) and American Express (NYSE:AXP) this week.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on June 29, 2020.
Jason Moser: It's Monday, June 29. I am your host, Jason Moser, and I'm joined today, of course, by the man with the plan -- and I mean that literally, because he's a Certified Financial Planner -- it's Mr. Matt Frankel. Matt, [laughs] how's everything going?
Matt Frankel: Pretty good. It's a nice, hot day down here, and things are reopening, and up there, they're jumping into the next phase. So it's a good day.
Moser: Yeah, a good day. Nice weather up here, starting to warm up a pretty good bit. Yeah, I think everybody is eager to try to keep on that road back to some sense of normalcy; and every day we're a little bit closer. But on today's Financial show, we're going to look at some of the results here of a few interesting polls that Matt put out over the weekend on Twitter. We're going to dig into a listener question that also came to us from a user on Twitter. And as always, we'll have One to Watch for you this week.
But first, Matt, we're going to dive into an interesting development here that grew over the weekend. And you put an article out regarding this as well and we'll tweet that out on the feed, but the article is entitled "Are Your Bank Stock Dividends in Danger?" And this essentially was in relation to the news that the Federal Reserve said that banks will not be allowed to repurchase any stock during the third quarter, no dividend increases for the third quarter, all of the banks will be required to resubmit capital plans later in 2020. And this is really all the product, all the byproduct of the stress tests that the banks recently underwent. And it just sounds like basically regulators could see a scenario, in pandemic times, where some of these banks could be caught between a rock and a hard place. So why don't you dig into a little bit of that for us, explain exactly what's going on?
Frankel: Yeah, I don't think the buybacks were necessarily the big news, just because, I mean, to my knowledge, pretty much every bank has already discontinued buybacks; they did that voluntarily to preserve capital. The issue is that banks could be forced to cut their dividends. So just to kind of give you a little bit of background, the Fed announced the 2020 stress test results, like it does every year, but instead of just looking at the normal recessionary scenarios, which they normally use to stress test the banks, they made a special stress test, if you will, for the COVID pandemic, it looked at some pretty adverse conditions. Unemployment peaking at 19.5% was one of them; which right now unemployment is, like, 13%. A long U-shaped recovery, a W-shaped recovery where it, kind of, it's a double dip, which isn't the most likely scenario, but, you know, their job is to test the worst-case scenario.
And they found that under some of these worst-case scenarios, bank losses across the 33 banks subject to the test would be as much as $700 billion as a result of the pandemic. That's $700 billion of loans that people couldn't afford to pay back that would eventually be charged off. Now, that's not a prediction, so don't take this as the Fed is saying that's what's going to happen. The Fed is saying that under a terrible scenario, that that's what could happen.
So under a scenario like that, the Fed found that banks would stay above the levels of capital needed to operate. You know, we're not going to have another Bear Stearns or Lehman Brothers going on, in other words. But under the worst-case scenarios, some of the banks would approach minimum capital levels, and that's concerning to the regulators.
So what they did is they imposed a rule -- as you said, they have to resubmit their capital plans later in 2020. In the third quarter, dividend payments are allowed. There's no dividend increases allowed. So in the best case scenario, your bank stocks will be paying you the same dividend rate they paid last quarter, which is -- you know, the third quarter is generally when banks raise their dividends, because that's when the stress test comes out. So that's a no-go this year. And dividends are only allowed based on a formula based on the average of the bank's net income over the four previous calendar quarters. So in other words, one bad quarter of losses doesn't necessarily kill the dividend, but if a bank has been, like, just borderline been able to cover their dividend and then has a, you know, a big COVID-related loss, that could cause a dividend cut.
We don't know yet which individual banks might cut their dividend. Wells Fargo is one of the big highly speculated ones, just because of their giant exposure to consumer banking relative to some of the other banks that have investment banking divisions and things like that. So we'll actually find out later today; banks are allowed to, kind of, come out with their own statements saying what's going to happen. But long story short, bank dividends suddenly became more of a fluid concept than they were a few days ago. [laughs]
Moser: [laughs] Yeah. You know, I was thinking about this as I was reading through everything. And to me, this isn't terribly surprising. When you see the number of homeowners who are applying for forbearance these days, I mean, those numbers are high. They are abnormally high. That's for understandable reasons. I mean, the COVID-19 pandemic has really stuck it to a lot of people, and you know, folks are having a tough time making ends meet. That's certainly understandable.
And so, I guess, when I was reading this, to me at least, it felt like, it may seem kind of like a bad-news headline when you see it on its own, but when you really get right down to it, this is actually good in the sense that it's doing what the stress tests were really intended to do. I mean, it's good that we have this framework that we can put these banks through in order to avoid the degree of something like the financial crisis that we witnessed over a decade ago again. So I mean, I don't know. To me, you know, I can see where people would be worried about the headline, but ultimately, I see the logic, I understand it, I'm not worried. I mean, is this something that bothers you? Is this something that you feel like investors should be worried about?
Frankel: Well, it's a big question of uncertainty. The stress tests are designed to kind of gauge uncertainty, and right now uncertain is off the charts, especially when it comes to banks. Like, for example, we said unemployment at 19.5% is the worst-case scenario that they're testing out. Well, for the time being, most people who are unemployed can afford to pay their bills; they are getting an extra $600/month in unemployment benefits through the end of July. So will that run out? Will it not run out? Will the government extend some sort of support? You mentioned all the forbearances and things like that, are people taking them because they need them right now or people taking them just because they're guaranteed to get one?
And banks are pretty much giving mortgage forbearance to whoever needs it, auto loan forbearance, credit card forbearance. It really hasn't been hard to get a forbearance if you wanted one. So the question is, are people taking these because they need them, because they won't be able to pay their loans without them, or because they're just available? So it's really tough to say right now what the long-term economic effect of the pandemic is going to be. And the uncertainty spectrum is just off the charts right now. And when the stress test is testing the worst end of that uncertainty spectrum, you're going to see some pretty dire results, so I'm not terribly worried about it.
I own a lot of bank stocks, as you know. Next to real estate, I call it my second-favorite sector. But I own a bunch of bank stocks, and I'm not planning on getting rid of any of them soon. And I think any dips that come on the heels of this news could be a buying opportunity for long-term investors. In the short term, I'd expect kind of a little bit of a roller coaster ride till we get more clarity.
Moser: Yeah, I'd imagine you're right there. The one thing that I started thinking of. You know, it's a very, very big world of banks. All the way from small banks to your mid-tiers to your big boys and one of the questions I immediately knew I was going to be asking you, when I knew we were going to be talking about this on the show is, what banks are poised to be able to come through this better than others? I mean, as an investor, certainly, you have to be looking at a couple of banks that you feel like are going to be able to manage their way through this better than others. Any out there that investors need to be keeping a close eye on?
Frankel: Well, first of all, it's actually really important to point out that there's a chance that none of the 33 banks will have to immediately cut their dividend. Again, the formula is based on the last four quarters of earnings, and until this past quarter, most banks have been very profitable. So the one big bank that I'm concerned about is Wells Fargo.
Moser: I mean, that makes sense. They have a very large mortgage presence. That does make sense.
Frankel: Right. They have a large mortgage presence. They're pretty much exclusively focused on consumer banking. I don't want to say they have no investment banking, because their people reached out to correct me [laughs] a few weeks ago, actually, because I kept saying that, but they have very little investment banking presence. So they're pretty much levered to the health of the consumer. And based on the current share price, I think Wells Fargo's dividend yield is well over 8%. So even if they cut it, they'd probably still be a high-dividend stock.
So out of the big banks that's the one that I would worry about. For the most part, I don't think anyone is going to have to cut immediately -- we'll find out today. Maybe I'm wrong, but I don't think we're going to see a wave of bank dividend cuts today.
Moser: Yeah, I bet you're right. And there is the big question mark of the back half of this year, right? I mean, there's just so much that you just simply don't know. And I mean, if these outbreaks continue to gain traction and more states have to walk back their reopenings a little bit, I mean, there is a massive chain reaction that kind of goes on from something like that that you just can't -- you could flip a coin today to say whether it's going to happen or not, you just don't know.
Frankel: Right. On the rollbacks of reopenings, a lot of it's just kind of like, reverse common sense, I'd say. [laughs] You know, crowded bars probably shouldn't have been opened. [laughs]
Moser: I would argue that is correct. And thankfully, for me, you know, I'm an old guy now, so I don't go out to bars and hang out. So thankfully, that's not crimping my lifestyle. But man, Matt, I remember when I was younger very well, and this would be crimping my lifestyle. So I certainly understand folks who are champing at the bit to get out and do stuff. And, you know, it's been a tough year thus far. It doesn't sound like it's going to be getting any easier, at least in the near term. But you know, at the end of the day, for me at least, I take solace in knowing that this was the point of the stress test to begin with. I mean, this is ultimately something that, to my eyes, it's a net positive for investors, particularly investors in the financial sector.
Frankel: Yeah. No, the stress tests are definitely a good thing; we need the stress tests. And the big important thing is, it's not that these banks were in danger of failing the normal stress tests that we've seen year after year after year after the financial crisis, they added the special scenario in for COVID, just, you know, worst-case COVID recession. And none of the banks failed, they just kind of brushed up against the minimum capital levels is what it sounds like. So no, it's definitely a net positive. It shows the relative health of the banking system compared to before the Great Recession. In 2007, for example, I don't know how many banks would have passed the COVID test. They didn't pass the normal recession test [laughs] back then, so.
Moser: Yeah. And I guess it's just that old adage, you just prepare for the worst and then hope for the best. And if you do that, you'd probably keep yourself up in pretty good shape.
Matt, let's jump into a couple of polls that you fired off over the weekend here on Twitter. I like these. I voted myself, and I will reveal what I voted for.
Frankel: Yeah, people were asking. [laughs]
Moser: [laughs] In good time. But let's look at the first one here, because I thought this was a neat question, I like the idea behind it, particularly, given that we've been talking a lot about real estate investment trusts recently. And the question you asked, you asked, the best type of commercial real estate to invest in over the next 10 years. And if your favorite isn't on the list then write it in. But we're just going to go with the four options that you gave us for the best type of commercial real estate to invest in over the next 10 years.
You had the option of: retail, data center, industrial, and residential.
And overwhelmingly, more than 55% of the votes voted for data center. And I will tell you, I too voted for data center. And you know, a lot of that just has to do with this understanding that the world is just awash in data. I mean, this 5G rollout and as technology continues to get better and everything is connected, Internet-of-Things and smart cities. And just there's a ton of data out there, it does feel like that's a good opportunity. I have a feeling maybe though -- and I don't know what you voted for -- but I have a feeling that you did not vote for data center or you would not have voted for data center. But what was your thinking there as the data center winning the majority of the votes?
Frankel: I wasn't surprised to see the data centers winning. One, they've been the best-performing type of real estate investment trust during the pandemic. The pandemic itself was actually somewhat of a tailwind as people work from home more, there's more data flowing from remote locations than ever before. The rollout of 5G is going to be a big catalyst. Demand for data centers is not going anywhere, in short.
The one thing that surprised me and the one I voted for, was industrial.
Moser: See, I actually would have guessed you voted retail. That was just based on our retail conversation from a couple of weeks ago.
Frankel: [laughs] I like retail, but the best type to invest in, you know, on a risk/reward basis, I would have to go with industrial. Industrial means things like warehouses, distribution centers. Those giant Amazon buildings are types of industrial real estate. I like industrial as a play on e-commerce. The need for warehouse space and fulfillment space and things like that is not going anywhere. As more retail shifts online, we're going to just need even more.
Prologis is the biggest in the space, and they put out a statistic that says when a retailer shifts from a physical presence to an e-commerce presence, it needs 3X the distribution space. So that's a big catalyst going forward. That was what surprised me. I wasn't surprised that residential finished second, you know, that's a pretty good place to be. You know, the millennial housing boom is coming. The millennials are, kind of, getting into their primary household formation years.
But I was surprised that industrial didn't do better. You know, e-commerce is such a big trend, and I'm surprised people didn't think of real estate as more of a way to play it. I'm not surprised retail finished last, I will say. You know, I mean, there's more retail REITs than I like. My Retail Isn't Dead (sic) [Physical Retail Isn't Dead] basket, which I published a formal article on this week. I put pen to paper and formalize that.
But I think there are some good opportunities, but as far as best from just a pure investment, you know, best risk-to-reward potential, I can't make the case that retail is the best place to be. So I wasn't too surprised; I was surprised that industrial didn't do a little bit better.
Moser: Well, the second poll that you put out there was another fun one. And I wasn't surprised to see the results. But, you know, it's an interesting one to think about regardless. This has to do with the war on cash stocks, the war-on-cash basket. So you asked the question, which war-on-cash stock has the best chance of doubling from its current share price within three years? And you had the options there, the war on cash holdings in Square, PayPal, Mastercard, and Visa. And it's important to note, you were talking about the share price doubling, not the market cap doubling, because that can be different, especially when you consider the share buybacks from some of these companies.
But, you know, I wanted to go ahead just to give a quick rundown of the performance of these stocks in the war-on-cash basket. Since it was started back in July of 2017. The basket itself is up almost 175% versus the market's 30%. But it's interesting to see how the stocks have performed, because as of right now, Mastercard is up 128%. Visa is up 93.5%. PayPal is up 186%. Square is up 287%. So three of the four have at least doubled since inception. And Visa, actually, at one point, had doubled; I mean, it pulled back a little bit.
I wasn't surprised to see the results here. Square was the overwhelming one with 71.4% of the votes. You know what, though, I actually might have gone a little contrarian here, I voted for PayPal. I would be interested to know what you voted for.
Frankel: Well, I voted for Square, you're probably not surprised to hear that. I was surprised at the margin of victory. I figured a few more people would have said PayPal. I'm not surprised at Mastercard and Visa. They are huge companies, it would take a lot for them to double. The same reason that I think Markel has a better chance of doubling than Berkshire Hathaway, just because sheer size alone is a factor. And Square is by far the smallest of the four in terms of market cap, by far. So I'm not surprised Square won; I'm surprised at the difference. And like you said, PayPal does some buybacks, I think, if I'm not mistaken.
Moser: They do some, but they've been focused more on investing their money and really trying to grow that business.
Frankel: Right. Well, Visa and Mastercard pay dividends. They're the only two out of the four that pay dividends. And they are the only two that are aggressively buying back stock, I would say.
Moser: Yeah. Well, I mean, that seems like it's really part of the thesis in investing in those two companies, given how big they are, I mean, you do have to account for the fact, they buying back shares is part of the thesis, because it brings that share count down and can help keep that P/E ratio somewhere where the market is going to be excited about the stock.
Frankel: So if, say, Mastercard and Visa were to buyback, you know, over the next three years, which as I said in this poll, if over the next three years they bought back, say, 15% of their shares and paid another 5% total in dividends, then that kind of lowers the bar to how much the share price would have to gain for it to double. So it's not inconceivable that Mastercard and Visa would double. I mean, combined, they got about 11% of the vote. And I'm not surprised, like I said; they're the two biggest companies on there by a good margin, but it's not impossible for them to double. I mean, there's a big market opportunity, both of them are growing earnings at, you know, close to 20% a year. So it's really not inconceivable for either of them to double. I mean, your war-on-cash basket, all four of them could double for all we know.
Moser: Well, and that's just it. I mean, to this point right now, that's essentially three years since inception. And we've seen three of the four have doubled, but all four of them had doubled at one point or another. So it could certainly happen again, there's no doubt about it. But, you know, hey, listen, we continue to like that market, certainly still like all four of those companies, but just another interesting way to think about them and the opportunity they still have out there in the market.
Speaking of opportunities in the market, and this is a listener question we received from a listener on Twitter, Cameron Colinas. And Cameron reached out asking a question -- it's not really a financials company, although I guess we could say it is in the sense that it's Shopify and they have that Stripe dynamic; which Stripe not being a publicly traded company, if you wanted to get exposure to Stripe then you could just invest in Shopify, and there you go.
But I thought it was a good question. It sure is one that I think a lot of people have to think about from time to time, particularly these days as so many of these stocks have just done so well in, really, a fairly short period of time. And Cameron asks, he says, "I have been invested in Shopify for a few years, so naturally it's become a large part of my portfolio. Every time it would get over 20% of my portfolio, I would sell some so that it didn't become too much. Every time, I've regretted selling any. [laughs] Is my philosophy wrong? Should I just let my winners run no matter how much of my portfolio they become?"
And you know, I thought this would be a fun question for us to tackle because I'm sure that you and I -- I know that I certainly have had this "problem." I mean it's a really nice problem to have, no doubt. But it's something that does require some thought. And it's not a cut-and-dry answer, right, it's going to be a little bit different for everyone, but what's your perspective on that, Matt?
Frankel: Well, I mean, the general Foolish mindset, if you will, is to add to your winners, as we just said. Having said that, it depends on your personal risk tolerance and how comfortable you are having enough of your money or so much of your money in one stock. I mean, it could have completely gone the other way every time you sold. And you would've been happy you sold some of it.
I'll tell you that I'm currently wrestling with a similar decision. The biggest stock in my portfolio by far now is Apple. But my cost-basis in Apple is under $100/share, and Apple is currently at about $360. So yeah, I mean, it's a good problem to have. But now I'm brushing up against that 20% mark, I think, and I'm personally not that comfortable having more than 10% to 15% of my money in any given stock.
But at the same time, similar to Shopify, it's really hard for me to make a case against Apple in terms of, in a worst-case scenario, how badly would Apple stock price do, in other words? I couldn't see it going back to the $100 level right now, no matter what happens; their ecosystem is just too strong.
So in my mindset, it's, yes, I have a little too much for comfort, but I have too much of my money in a stock that I consider very safe at this point. So it's kind of a conundrum that I'm wrestling with right now. And by talking about it again this week, I did the same thing last week, by talking about it, I'm committing to not selling any of it any time soon. But having said that, it's definitely a -- again, it boils down to a question of risk tolerance. Jason, how much of your portfolio is in your biggest stock? Like, what percentage, ballpark?
Moser: That's a good question. This is one where I would say, do as I say, not as I do, because I certainly consider myself to have a very high risk tolerance. I don't have any problem seeing a position get upwards of 40% of my portfolio if it's a company that's winning and it's growing. So I think that's really one of the first things to determine is, you know, it's one thing to buy a certain stock and make it that large of a percentage of your portfolio. it's another thing entirely to buy that stock and then watch it grow into being that outsized portion of your portfolio.
That's a little bit of a difference there in my mind because it feels like, you know, one, you're benefiting from the success of the investment. I mean, the fact that it's taking up more of your portfolio is just a sign of its success. And so, for me, I would say, round number, I think my largest position is probably somewhere in the neighborhood of around 40% maybe, maybe not quite that much, but it has grown into that. It's not something where I bought that amount. And so I think that's always something worth considering.
But to your point, it is dependent on your risk tolerance, everybody is a little bit different there. We always talk about sleeping at night, sort of, litmus test there, right? I mean, if it's something that's keeping you awake with worry then that's your answer, you need to trim that position back, because if you're not sleeping well at night because you're afraid you're a little bit too exposed I think that makes sense to trim it back. I mean, when you look at a company like Shopify, and I do own shares of Shopify myself, I think probably the biggest risk to a stock like that is the valuation. I mean, the valuation is detached from the fundamentals of the business, but we've also seen that the market will give companies like that a lot of room to run if they are good, successful businesses pursuing massive market opportunities. And that's really what Shopify is. So yeah, I feel like that sleep-at-night test, that's kind of the one I always run through my head, and if I'm not sleeping well, then I start to think about how am I going to pare that position back.
Frankel: Right. And Shopify is not a low-volatility stock, so, I mean, I at least don't think it is by my standards. So I'd be nervous having too much of my money in a stock. Like, Apple, I consider a relatively low-volatility stock at this point. So that's why I'm comfortable, for the time being, keeping that much of my portfolio in Apple, but Shopify is a higher-volatility stock, so that comes into play with the risk tolerance equation as well.
Moser: Yeah, it is. And, Cameron, it looks like you are a younger investor, so it looks like you are in that position where you're looking to grow your wealth as opposed to worried about protecting your wealth. And I think that you're at the point in your life where you can feel comfortable, or feel OK at least, taking on a little bit more risk, because you have a lot of time, really, to make up for any potential mistakes. But, yeah, that's a tricky one. You know, that's always a tricky one.
And we certainly recommend in our services, the services that I run in the Next-Gen Supercycle and the Augmented Reality and Beyond, typically we recommend for investors, you know, depending on the size of the business, whether it's a small-, medium- or large-cap company. I mean, you're not looking for any one of those positions to take up more than 4% or 5% your overall portfolio. Those are guidelines, right; it all ultimately does depend on you and your risk tolerance as an individual. So I hope that's helpful. I mean, certainly, it sounds like, you're benefiting from a nice problem in that Shopify just keeps on winning for you. And maybe you just sort of let that thing keep running. And you just enjoy the success there.
Frankel: Yes, it's definitely a good problem to have.
Moser: [laughs] Yeah. If you can't sleep at night, then, yeah, I think that's where you got to look at paring back that stock a little bit to where you feel OK sleeping at night. But anyway, thank you for the question, Cameron. Very, very good thought exercise there, and one for all investors of all ages to consider.
Matt, before we wrap it up here, we want to give our listeners One to Watch for this coming week. So I'm going to let you kick it off here, what's your One to Watch this week?
Frankel: I'm going with Wells Fargo just because I'm really curious to see what happens with these stress tests. I like Wells Fargo's business, if there is a dividend cut, I think it's going to be, you know, like an abundance of caution, kind of like we've seen a lot of the real estate dividend cuts. And I think a dividend cut would cause the stock to go down, but I think it would be a buying opportunity, so I'm watching Wells Fargo.
Moser: Nice. And that ticker?
Moser: WFC. All right. Well, I'm going with one of your favorites, Matt, American Express, ticker AXP. You know, if I was going to extend my war-on-cash basket, American Express very well would be in the running there. I'm still a cardholder myself, as a matter of fact. But I saw a really neat story here recently. American Express cardmembers now -- in order to help boost small businesses that have really been suffering from the pandemic, American Express cardmembers will receive a $5 credit for every $10 spent at a small business using their American Express card. You can use that up to 10 times between now and September 20, for a total of as much as $50 in shopping credit.
So I thought that was a neat little feature that they were adding. They certainly are doing, I think, a good job of, you know, they're expanding that customer base, it's been so long they had that reputation it's a card for the rich, I guess, but they really have done a good job of making it now that they've got a card for everybody, it feels like. But you know, when I look at the stock itself, and the shares have had a tough year, down around 25%. Right now, it's trading around 14X trailing earnings, 1.8% dividend yield. And we've talked about this before, it is a bank, so they are subject to those regulations and stress tests and whatnot. But it really does feel like one of the stronger brands out there, and obviously a very well-run business with a little bit more control over their cardholder ecosystem. And so I think definitely American Express is one to keep on the radar. You like that, don't you, Matt?
Frankel: I do. That was the first fintech stock, I guess you'd say, that I ever bought, and I still own it today. And I wonder where you got the idea to add it, to make it the fintech in the war-on-cash basket, that's all I'll say about that. [laughs]
Moser: I can neither confirm nor deny that you may or may not have had something to do with that, Matt. And we'll just leave it there. [laughs]
Matt, listen, thanks again so much for joining us this week. It was good talking to you again. And I hope that good weather stays good for you down in South Carolina. And hopefully, this summer shapes up to be a beautiful and healthy one for everyone.
Frankel: Yeah, and Happy 4th of July to everybody listening out there.
Moser: Indeed, that's right, remember the markets are closed on Friday, and that means The Motley Fool will be closed on Friday as well. But for now, that's going to do it for us this week, folks.
Remember you can always reach out to us on Twitter @MFIndustryFocus, drop us an email at IndustryFocus@Fool.com, if you have any questions, let us know, we love to bring them on to the air and help you out anyway that we can.
As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.
Thanks, as always, to our man Austin Morgan for taking care of us each and every week. For Matt Frankel, I'm Jason Moser. Thanks for listening, and we'll see you next week.