If You Own a Bank Stock, Then Make Sure It’s One of These…

To paraphrase a frequently-cited Warren Buffett quote, it’s only when the tide goes out that you can see who has been swimming naked. To build on his analogy, the financial tide went out quickly during the credit crisis and left many banks without the proper swimming attire to make it back to shore with their reputations intact.

Banks with overly aggressive growth ambitions or poor loan underwriting standards didn’t even make it back to shore at the peak of the crisis. Specific firms such as Washington Mutual, Wachovia and National City Corp were left holding too many failed mortgage loans. As a result, they were bought out for a fraction of the value they had prior to the crisis.

Those that survived have seen their competitive positions strengthened by fewer rivals in the marketplace. Additionally, the worst is likely over and the industry has now had a couple of years to rebuild balance sheets and return to more normal banking conditions. Smaller banks are arguably in the strongest position and could see strong share price performance in the next couple of years. Many were well-run prior to the crisis, and their small size makes it easier to grow their asset bases and acquire rivals.

Here are three regional banks you should consider owning. All three have appealing outlooks, which stems from a combination of profit recovery, continued growth potential and ability to buy market share.

1. Fifth Third Bancorp (Nasdaq: FITB)
Market Capitalization: $11 billion
Current Dividend Yield: 1.9%
P/E: 10.7

Cincinnati-based Fifth Third Bancorp  had a rough 2008 as the credit crisis reached its peak. The bank chose to take funds from the government through the Troubled Asset Relief Program, or TARP. It finally repaid $3.4 billion in government funds it borrowed by issuing $1.7 billion in stock in January 2011 to put the worst behind it and return focus to running and growing its banking business.

Fifth Third’s investment potential going forward lies in a continued recovery in its business and expansion into faster-growing states. Last year, the bank earned only $0.63 per share, which represented a return on equity (ROE) of only about 5.4%. In the next couple of years, ROE has the potential to double to 10.8% and suggests earnings close to $1.50 per share.

This is certainly achievable. ROE was higher than 11% before 2008, and the bank has plans to grow in existing Midwest markets and also in states such as Florida that should see above-average population growth in the future. The bank also has the potential to increase its dividend yield to back above 4% as earnings return to more normalized levels. By assigning a reasonable P/E of 12 and the normalized earnings I mentioned above, the stock can appreciate 45% from current levels and eventually reach $18 per share. 

2. PNC Financial Services Group (NYSE: PNC)
Market Capitalization
: $31 billion
Current Dividend Yield: 2.3%
P/E: 9.9

Pittsburgh-based PNC Financial Services Group used the credit crisis to its advantage by taking out weaker rivals. It remained firmly profitable during 2008, though earnings did fall by more than 40% from the previous year to $2.44 per diluted share. Despite this dip, PNC’s loan losses were much smaller than other peers and allowed it the opportunity to buy out beleaguered Cleveland rival National City Corp in October 2008 for less than $6 billion. PNC’s aggressive takeover strategy continued when it closed on the purchase of Royal Bank of Canada’s U.S. business in June for an estimated $3.5 billion. The deal adds more bank branches and the opportunity to improve profitability to levels seen at its existing bank network.

PNC’s ROE remains strong and came in at 10% in 2010. It can still improve from where it stood prior to the credit crisis. This can happen through organic growth, improving profits from acquired banks and continuing to buy out rivals. Overall, earnings have the potential to rise to more than $6 per share while the dividend yield can return to close to 4%, which is where it stood back in 2007. PNC’s historical P/E has averaged around 13 and suggests the stock can eventually reach $78, good for a 32% gain.

3. U.S. Bancorp (NYSE: USB-PH)
Market Capitalization: $48 billion
Current Dividend Yield: 2.0%
P/E: 11.5

Like PNC, US Bancorp managed the heights of the credit crisis well and stayed firmly profitable through 2008 and 2009. It was also one of the only banks to grow through the crisis, which speaks to its conservative philosophy toward making loans. This helped the bank avoid the severe mortgage losses that hit the weaker players during the financial debacle. The bank also pursues a disciplined acquisition strategy by strategically buying out smaller rivals over time. For example, back in January, it acquired First Community Bank, a small banking operator in New Mexico.

Last year, US Bancorp’s ROE remained strong compared with rivals, coming in at almost 11%. But this was about 50% off from its highs of 22.4% back in 2006. If it returns to 20%, earnings should hit more than $3 per share. This is possible within the next couple of years as business recovers along with the economy. The bank’s historical P/E has averaged around 13. By applying this multiple to the earnings expectations, I think the stock could gain 53% and reach $39.

Action to Take –> Fifth Third qualifies as the value pick of the stocks I’ve profiled because it carries a low earnings valuation and is still recovering from the credit crisis.  PNC offers a mix of value and growth. The stock carries an even lower valuation and profits have remained stable, yet have continued steady-growth potential. U.S. Bancorp should continue to grow its business yet also has the potential to post ROEs that can be among the highest in the banking industry. A high potential ROE means higher potential earnings and the biggest upside of the group.

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