Banks: Crummy-to-Mediocre or Good-to-Great?

Jack Hough, one of our favorite investment writers, in Barron’s this past week asked around among money managers for stocks that could double in the next five years, and it was little surprise that beaten-down Bank of America (BAC) made the list.

The banking giant, the result of many an ill-considered acquisition -- most notably Countrywide, the mortgage giant that saddled BofA with tens of billions of dollars in losses and mountains of still-festering litigation – is up by almost 60% over the past year, as seen in a stock chart.

BAC Chart

BAC data by YCharts

Certainly, as it works through its mortgage-related and other loan losses, BofA’s profits will rise, it will likely be green-lighted by regulators to bump up its now-paltry dividend, and the stock should follow along.

One question for investors wanting exposure to the financial sector, however, is how certain we can be of BofA’s recovery and whether an already-healthy bank isn’t a better bet. In other words, do you prefer Crummy-to-Mediocre, or, say in the case of Wells Fargo (WFC) or US Bancorp (USB), Good-to-Great?

The latter two banks have little of the investment banking and trading operations that made JPMorgan Chase (JPM) and Citigroup (C), and to a lesser extent BofA, more volatile and, over the long haul, less profitable. And US Bancorp and Wells Fargo – both held by Warren Buffett’s Berkshire Hathaway (BRK.B) – have demonstrated an ability to achieve superior returns over sustained periods of time. BofA, JPMorgan and Citigroup have not.

BAC Return on Assets Chart

BAC Return on Assets data by YCharts

Let’s assume that all the banker bellyaching about Dodd-Frank is correct and that it’s going to limit profitability going forward, and thus pre-financial-crisis levels for return-on-assets are the best achievable. And let’s also assume that the managements of the five banks have the skills and will power to get their institutions back to those lofty levels; that, by the way, is a big assumption with BofA’s CEO, Brian Moynihan.

Moynihan -- or, should he stumble, his successor – would be fortunate under these assumptions to get BofA back to 1.5% return on assets. The 10-year record hardly encourages one to expect Citigroup or JPMorgan to hit that level consistently, either. But US Bancorp and Wells Fargo – these are deep management teams with demonstrated commitment to incremental improvement – seem more likely to regain a return on assets of close to, or even above, 2%. And their business model holds less risk, so over time the market could be expected to pay up a bit for those returns.

BAC Forward PE Ratio Chart

BAC Forward PE Ratio data by YCharts

Based on forward PE ratio, BofA is expected to significantly improve results, relative to the other Big Five banks. And it likely will. But with forward PE ratios below 12, Wells Fargo and US Bancorp are hardly pricey. And the biggest surprise at those two companies would be if they failed to significantly improve returns, dividend payouts and, of course, overall shareholder returns.

Since mid-May, when the Federal Reserve Chairman stepped up warnings that there indeed could be an end to the central bank’s bond buying, sending rates higher, investors have pulled back from banking’s two relative basket cases, BofA and Citigroup, and given moderate votes of confidence to JPMorgan and especially to US Bancorp and Wells Fargo.

BAC Chart

BAC data by YCharts

Oh, Jack Hough's other five stocks with the potential to double in five years were Hewlett-Packard (HPQ), ITC Holdings (ITC), Oracle (ORCL), Sprint Nextel (S) and Steiner Leisure (STNR). If those sound interesting, YCharts can help you get started with some financial research.

Jeff Bailey, The Editor of YCharts, is a former reporter, editor and columnist at the Wall Street Journal and New York Times. He can be reached at editor@ycharts.com. You can also request a demonstration of YCharts Platinum.

Read more articles about: Company Analysis  bank stocks   return on assets   

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