Today the banking industry may once again be sitting at a turning point. First, there was the financial crisis. Then there were the years of growing pains while the industry adapted to the post-crisis world. Today, all of those changes are pretty well established. The markets don't care about what happened yesterday; they care about what these big banks are going to do this year. It's time to put up or shut up.

In this episode of The Motley Fool's Industry Focus: Financials podcast, host Gaby Lapera and analyst Jay Jenkins break down the forces driving big bank valuations today and try to read the tea leaves on where the market will push this industry next.

A full transcript follows the video.

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This podcast was recorded on Feb. 22, 2016. 

Gaby Lapera: The Big Banks Theory. This is Industry Focus: Financials.

Hello, everyone! Today is Monday, Feb. 22, 2016. This is Gaby Lapera in the studio. We recently decided to change things up on the Financials edition, so we're having a rotating cast of analysts from now on. Joining us this week is Jay Jenkins. Thank you very much for agreeing to this.

Jay Jenkins: I'm glad to be here.

Lapera: I'm really excited to actually have you on. Maybe you'll be able to come up with more clever opening lines than me. I feel like "Big Banks Theory." Like Big Bang. I thought it was funny in my head and then I said it out loud and I was like, "Ugh, that was terrible."

Jenkins: Not the most glamorous niche, that is for sure.

Lapera: No. But, this week, actually we're kind of doing a listener question. I don't know what happened, but this guy named Derek Stritzinger apparently read my mind and wrote in about the exact topic that we already had planned, which is whether or not if this is a good time to buy big banks. I don't know if you noticed, Jay, but the market has had kind of a rough start this year, although it's kind of rebounding. So, everything's just kind of on sale, even great companies, just because the market as a whole is down. So, the question, like I said, is, is now...

Oh! You know what I almost forgot, actually? It is 13F season. And I bet 13Fs would give us great insight onto -- well, maybe some insight as to whether or not it's a good time to buy big banks right now. Did you get a chance to look into those?

Jenkins: Yeah, that was actually my first thought as we started talking about how we were going to approach this question. So, I went back, reviewed--

Lapera: Oh, sorry, I'm going to interrupt you really quick -- just for our listeners, 13Fs, in case you don't know, are an SEC filing that institutional investors have to file, and it basically says what they're investing in. That's anyone from like hedge funds to big banks to individual investors like Warren Buffett or Jamie Dimon. Sorry, continue.

Jenkins: Yeah, that's exactly right. Good explanation. So, the beauty of it, the value of it, is that we can see what the "smart money" on Wall Street is doing. One of the downsides is that there is a delay. So, the market, like you said, has been kind of crazy since January. So we won't know how these big hedge funds have reacted to that until next quarter, when they release their first quarter 13Fs. So we are kind of looking in the rearview mirror a little bit with this. With that said, when I went back and looked at these large firms, these... if there is a household name of hedge funds, these are them -- there's really not a whole lot of unusual activity in the big bank space.

JPMorgan (JPM 1.44%), Wells Fargo (WFC -0.26%), Citigroup (C 2.82%), Bank of America (BAC 1.70%), all the usual suspects, these huge, huge megacap banks, they're the most widely owned. They are being traded. Some are buying, some are selling, but there's really not a consensus, no large directional change over the past year. So, again, that doesn't really indicate one way or another. But I do always like to check in on what the real big-money smart investors are doing. And in this case, it's sort of treading water, not really sinking but not floating any higher, either.

Lapera: Yeah, kind of just a wait-and-see thus far anyways. (laughs) 

Jenkins: Exactly.

Lapera: That's really interesting to me, because I feel like big banks are in a far superior position in terms of stability than they were prefinancial crisis, and the Fed finally raised the interest rate, which is good news for big banks. But, I guess I don't know, I feel like the picture isn't so grim. So, from the surface, it's like, "Oh, why wouldn't you invest?" Right?

Jenkins: Yeah, I totally agree with you. It looks a lot better than it did, say, in '07, particularly in '08 and '09, certainly. Rates have been low since then, and that's been a major drag on earnings. When you're a bank and you're in the business of lending money, higher interest rates mean higher income. So, as rates rise, that should be a uniformly positive thing, especially so at the larger banks. Again, the megabanks in particular. Even larger regional banks like U.S. Bancorp (USB -0.20%) or PNC Financial (PNC 1.08%) or even BB&T (TFC 2.05%), these banks have sophistication where rising rates should translate pretty strongly to increased revenues, and that should drive higher earnings as well. So, from that perspective, banks look to be on the cusp of a pretty nice jump, if they're valued now at, say, around numbers 10 times earnings, and earnings double, all things being equal, that should cause the stock price to rise as well.

Lapera: Right. OK, so, I guess, the way to think about this, it's not just, "Should I buy a big bank now?" This is The Motley Fool. We're never going to tell you yes or no. We're going to tell you, "Here are strategies for looking through really big banks, incredibly complicated 10Qs, to pull out the data you need." So, I think we've kind of got a start here. I think the best way to structure this -- just, to preface this, Jay, I don't know if you know this about me, but my mother is a life coach, and I was her little guinea pig growing up. So, pro/con lists were huge in my household, in order to make any decision. (laughs) Shout out to Mom. Thanks for doing a great job raising me, I think, anyways, personally.

So, why don't we do pros? What's looking good for banks right now? What kind of metrics do we look at that looks good for banks right now?

Jenkins: The first thing that comes to mind, I don't know if it's really a pro, but it's an interesting time to be investing in banks, because bank stocks are pretty darn cheap right now. Typically, you value banks based on price-to-book ratio or by price-to-earnings ratio. And by both counts, the big banks are cheap. I mean, as we're recording this, Citigroup is trading at about 55% of book value. Bank of America is even cheaper than that. JPMorgan is trading less than 1:1. Only Wells Fargo, of the megabanks, is above 1.1, and that's because their earnings are always so strong, and they do such a good job operationally. So, valuation-wise, big banks are definitely cheap.

The regional banks are also kind of cheap right now too, but tend to be a little bit higher. BB&T it trading just over 1 times price-to-book value, PNC slightly below, and then Huntington Bancshares is another, what I look at as a bellwether of the regional banks, is trading at about 1.1 times price-to-book ratio. Now, in the good times, you can see views ratios get up besides 2 times, 1.8 times, some banks even trade even higher. So, with that longer-term historical perspective, now looks like an OK time, only because the valuation multiples are so cheap.

Lapera: And I don't think it's because there's anything necessarily wrong with any of these businesses. Because I think the first thing a lot of people say to themselves is, "Oh, the market's valuing it cheaply." But I think, ultimately, while the market is eventually efficient with coming to terms with what a company's price is, I think in short-term moments like this, it's really hard to just look at the valuation and be like, "That valuation definitely says a lot about what's going on." You know what I mean? It's more of an average, is what you want to look at.

Jenkins: Absolutely. With the market being so crazy so far this year, is JPMorgan really worth 15% less today than it was two to three months ago? No, nothing really has fundamentally changed. People are just reacting and trying to make sense of it. That's, like you say, our short-term opportunity. Now, there's a reason that banks are trading so low. Everything has a cause and effect. And I'm sure we're going to get into the headwinds a little bit later. But, yeah, by and large, banks are pretty cheap right now.

Lapera: Yeah.

Jenkins: Even on price-to-earnings perspective, looking at, on a forward basis, Wells Fargo is trading just under 11 times forward earnings. JPMorgan at 9.3 times. Again, these are not expensive. You look at the chart and it's come down since middle of last year, but not crazily so. While they were maybe at 10-12 times back in July or September, just to drop from 10 times to 9 times or 11 times to 10 times, that's not a gigantic drop in terms of earnings. So, the market recognizes that these earnings are real, the banks are safer. And like you said earlier, too, it goes back to before the financial crisis. These banks are better-capitalized, there's less risk, they're de-levered. All these things are really positive, so that if there is some sort of, I don't want to say crisis, but some sort of significant headwind like a recession, or even just a correction in the market, fundamentally, these banks are much stronger, and should come out of this much cleaner than we saw in '08, '09, even in '10, '11, Bank of America had such a tough time.

Lapera: Yeah. Well, that was mostly because of legal fees, and they've put a lot of that behind themselves. Which opens the door for them to profit, because instead of paying out because they've lost legal battles or because they don't want to continue them anymore and they just want to pay people to go away, they're going to be able to use that money to reinvest in themselves (laughs).

Jenkins: Yeah, absolutely. And Bank of America is a great example. Like you say, they traded down, I want to say it was almost 0.25 times tangible book value at the nadir of that whole thing. And now, Brian Moynihan, their CEO, has done a fantastic job putting all of that rep and warranty risk behind them. That's done, that's over with, and he successfully finished the Project New BAC, their cost-cutting initiative. Billions and billions of dollars in cost savings. So, going forward, major improvements, even though there are certainly still some flaws and problems that all of these banks have to deal with. But, much different situation today than in '08 or '09. So, I see the risk. The downside is, I guess, in a better place now. So, the investor today has, I guess, less to worry about. There's no generational kind of event, at least as best as we can tell.

Lapera: Yeah. I actually want to get back to something that I mentioned earlier, which is, the Fed raised the interest rate, which is good for banks. They make more of a profit when interest rates are higher, because the loans that they give out have higher interest rates, they make more money.

Jenkins: That's right.

Lapera: So, what ratio does that display itself in? What does that mean for big banks?

Jenkins: Sure. So, with bank accounting, it translates to a metric called the net interest margin, or net interest profit. And essentially, what that is is the difference between what a bank brings in interest revenue from loans or debt securities, and what it pays out for its funding, whether that's short-term loans with other banks or a larger more significant contributor being your deposit account, so, the zero-point-whatever percent you get you on your savings account. So, the difference between those is kind of equivalent to gross profit at a more traditional, simple business model kind of thing. So, as rates rise, the interest rate they're going to be able to charge on loans and get from debt securities is going to tend to rise faster than what they'll pay out for their funding and to deposit orders. So, as that margin expands, it should correlate pretty directly to the bottom line, because the banks are already operating the branch network. They have all the expenses. It's really a scaleable kind of event, so it should have a pretty strong impact relatively quickly.

Now, the flip side, though, is the Fed has signaled that it's going to start raising rates, but it really looks like it's going to be a slow, multiple-quarter process. Who knows when we'll get back to 5%, even 6% federal funds rate, if we do during this cycle at all. We may not.

Lapera: Yeah, it's like, what, zero-point-something right now, it's not even 1%.

Jenkins: Yeah, 0.25% is the target, and I think the actual effective rate is slightly higher than that by a few basis points right now. But, in the historical context, that 25 basis point change is next to nothing, it's hardly a blip on the radar screen. So, while directionally it's good for the banks that rates seem to be about to rise, we still have a long way to go for them to actually materialize and start saying higher returns from that revenue source. So, as a forward-looking investor, it's something good that we think is coming. But will it be this year or next year or three years from now, it's pretty hard to say.

Lapera: Right. So, I feel like we've done the pros, do you want to get into the cons a little bit?

Jenkins: Sure. A lot of the things we've talked about as positives, the reasons that banks are trading cheap for example. We like the future of banks because of rising interest rates. Well, why doesn't the rest of the market recognize that? Why aren't valuations going higher? And I think it also comes back to what we talked about, the new world post-financial crisis. A lot of this comes back to regulations.

JPMorgan is a great example. JPMorgan is classified as the most systemically important tier of the new global systemically important financial institution capital requirement regulatory regime. It's a mouthful, and it's pure regulatory jargon, but the bottom line means that JPMorgan and other large banks have to carry more capital on their books than they ever had before. That means that they can't lever up as much, so your return on equity is going to be lower, return on assets are going to be harder, it's going to be harder to generate the same earnings per share as it was before. Just because you can't juice it when you're sitting on an extra capital buffer, that money's got to sit aside rather than actually be put to work to benefit shareholders.

Banks with simpler business models don't have this problem quite as much. I think U.S. Bancorp or Wells Fargo are great examples of that. They're not as global, they don't get into all the crazy investment banking stuff that JPMorgan or Goldman Sachs or some of these other banks do. So, for these guys, they don't have that same extra capital buffer requirement.

Lapera: But they do still have more than they used to, which I think is important to point out. Prefinancial crisis, they weren't required -- now, the federal government tells these banks whether or not they can even pay out a dividend that quarter.

Jenkins: Yeah, totally. The Basel Accords that are being unfolded are causing rising tides for small boats. In this case, that rising tide is more capital for all banks. 

Lapera: Yeah.

Jenkins: And then, on top of Basel III, Dodd-Frank is also having some major implications in terms of capital, but also in terms of costs. Net interest margins, we hope, are going to be expanding since the financial crisis, big banks have really struggled to overcome some of the cost burdens of dealing with Dodd-Frank, putting in the systems and bringing in the people to manage this whole gigantic transformation across the whole industry.

I've got an example for you on this. M&T Bank (MTB 0.81%) is a very high-performing regional bank in the Northeast U.S., headquartered in Buffalo. Over the last 30 years, I challenge you to find a bank that's done better for shareholders. I don't think one exists. But, for the last three years, the bank was handcuffed trying to acquire Hudson City Bancorp, which is 25% of the size of M&T Bank at the time. Regulators wouldn't let it go through. The only way they got approval, which just happened a few months ago, was by spending literally nine figure sums of money to completely revamp the regulatory compliance program.

Lapera: Oh, I remember this. Was this the one where there was a woman in, I think, it might have been Maryland, where she was laundering money and they didn't notice for like a year?

Jenkins: Absolutely. It's the Anti-Money Laundering compliances, really, where they got beat up. It's the kind of thing, too, from a consumer perspective, the bank needed to do a better job. But from an investor perspective, we're talking hundreds of millions of dollars over multiple years. The bank's profitability suffered, their efficiency tanked. It was an ugly scene. And the bank's only just now come through it. This is happening all over the country, at every different bank. Maybe not on this scale, maybe not the headline-grabbing $120-some million that they had to put into it. But small banks, large banks, medium banks, compliance departments are growing, these systems are complex. It takes a lot of resources and money to handle it. So, that's a real significant headwind, and that's not going away. For investors today and for investors tomorrow, that's a reality of being in the big bank business.

Lapera: Yeah, that's definitely created some very interesting currents in the banking industry, too. If you look, the Federal Reserve release reports periodically, and you can see that the number of banks in the country has decreased over time, and pretty drastically, not surprisingly, after the financial crisis, a lot of smaller banks got eaten up by big banks. And part of it was the regulatory requirements were much more stringent, and small banks just didn't have the capital to invest in themselves to get there.

Jenkins: Absolutely. For the community bank niche, less than $10 billion in total assets group, a lot of these banks are looking at it, going, "We have to merge to get to that $5-10 billion point, just to be able to absorb the cost at scale and still provide the kind of shareholder returns that people expect." They want to pay out a reasonable dividend, these banks wants to buy back shares, they want to post strong earnings and grow. For a lot of small banks, it's too much.

Lapera: Yeah. I'm sorry, I kind of diverted the conversation into small banks. (laughs) I know you love small banks, I'm sure it wasn't a problem for you.

Jenkins: (laughs) Yeah.

Lapera: But, let's actually flip it to the other side, which is big banks. Like, right now in politics, it's kind of a hot button issue, everything from Hillary Clinton's JPMorgan speeches, which she isn't releasing the transcripts to, to Bernie Sanders saying, "I want to break up the big banks," I mean, that could be creating some headwinds on these banks, don't you think?

Jenkins: Oh, absolutely. And it's coming from both sides of the political spectrum, just in subtly different ways. And even some neutral observers. For example, Neel Kashkari, who's the newest member of the Federal Reserve, he's the new chief in the Minneapolis bank, he came out in his very first speech in that position, which is a non-voting position, so he doesn't have that much influence over policy decisions at this present time, but it's still pretty significant given that he's a Fed president -- anyways, he came out and said, pretty much specifically, that the whole industry needs to be transformed. Bold changes, bold new rules, force these banks to be broken up. That's a dramatic change. Go back to Teddy Roosevelt 100 years ago, the last time we saw some of these populist calls to shrink corporate interest. Now, will that happen? Who knows, I don't have a clue.

But what it certainly does is create uncertainty for investors, and that uncertainty is a major headwind. You're going to invest your dollar into an asset, into this stock, you want to have some sort of reasonable expectation for what you're going to get next year, two years, five, ten years down the road. And when you have major political figures, the Fed, and potentially in the White House, and anywhere else, that really, really puts a question mark over what's going to happen, and that's driving, I think, uncertainty, and reducing valuations as well. So, yet another headwind from something external two fundamental bank operations.

Lapera: Right, and not only that, but the global economic situation is super uncertain right now between China and Europe, and especially with these global investment banks, and oil, don't forget oil... it makes it a lot more complicated. However, all of these things put together, that's part of the reason that the valuations are so cheap right now. And if you fundamentally believe in the business models of these big banks -- which, I don't think there's any reason not to. If you look at their fundamentals, they're doing fairly well. Considering how much regulatory money they've had to spend, how the depressed interest rate environment has affected them, I think these banks are really doing a lot better than I would have thought. (laughs) 

Jenkins: I totally agree, and for me, it boils down to the issue of quality. If you can find a bank that's a really quality operation, that's rock-solid fundamentally, those banks are going to do better in good times and bad. You can ignore a lot of these external factors. If you invest for five years, one or two quarters today is kind of insignificant in a lot of ways, so you don't have to worry about that. Banking is not going anywhere. People will need somewhere to deposit their cash, people will need help with their financials, people do need loans, people want to own houses, and in America, a mortgage loan is the most common way to accomplish that. So, in terms of quality, to me, I look at JPMorgan, and I encourage you guys to go look at JPMorgan's fourth-quarter and full annual results.

There's a chart in some of the material for investors that shows earning per share growth over the past 10 years, essentially since Jamie Dimon took over, and it is just the most beautiful, linear chart, straight up, barely a hiccup through the financial crisis, it's remarkable when you think about all the changes, all the stuff that's happened, the chaos between 2005 and today, and it's just absolutely remarkable how consistent and how profitable that company really is. And, in that context, you understand why Jamie Dimon was willing to plop down $25 million or whatever it was to buy JPMorgan's shares last/this month. When you look at that chart and that context, it's going from the lower left to the upper right just like clockwork. And to me, that stems from the quality. It's the operational excellence, the fortress balance sheets, and all these things, and then, of course, Dimon, I think, is a fantastic banker and deserves a lot of credit there, too.

Lapera: Yeah. For me, it's U.S. Bancorp. (laughs)

Jenkins: Yeah, it's a great bank. It's unbelievable...

Lapera: The efficiency ratio for them is insane compared to all the other big banks. I think it's somewhere in the high 40s or very low 50s. I think the next closest one is Wells, and that's a huge thing. And it is, you're right, a very simple business model. I know all banks say this, but they actually are fairly conservative underwriters. They do a really, really good job of making sure their balance sheet is in check.

Jenkins: I totally agree. And it's amazing that they can do it at the size they are.

Lapera: They're huge.

Jenkins: Yeah, almost $1 trillion in total assets at this point. And Wells Fargo is in that same sort of mold. Very conservative, ruthlessly efficient on costs, credit quality is always paramount, and it works. It speaks to that quality, like you said.

Lapera: All right, we are running out of time/have already run out of time (laughs). Thank you very much for joining us. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell the stocks based solely on what you hear. Contact us at [email protected], or tweeting us @MFIndustryFocus. Let us know if you have any questions or what your favorite bank stock is. Thanks very much, Jay, and we'll see y'all next week!