The Only Bank Stock Income Investors Should Own Right Now…

One of the strongest themes since the recession has been the remarkable amount of cash returned to shareholders through increased dividend payments. With corporate profits rising, investors hungry for yield are being rewarded for their hard-earned dollars.

That is, except for investors in bank stocks.

#-ad_banner-#While dividends from companies in the S&P 500 have increased at an annual rate of 4.7% since 2007, dividends paid on the Financial Select Sector SPDR (NYSE: XLF) have declined an annualized 12% over the period.

Dividend growth on the financial ETF has picked up, growing an annualized 22% over the last three years, but the yield is still a feeble 1.6%. That is under the 1.9% yield on the broader market and well under the 3% yield paid on the fund at the end of 2007.

Financials are just now beginning to feel comfortable with increasing their cash payouts and investors may be in for a surprise as the sector boosts its yield over the next year.

Acquisitive Growth And  A Strong Yield That Could Go Higher
What’s better than increasing sector-level yields? Finding a best-of-breed company that already pays a high yield and may be ready to take it higher.

This bank is working through an acquisition that closed in 2013 and made it the sixth-largest bank in the Midwest with 400 locations and 440 ATMs in Ohio, Michigan, Wisconsin and Pennsylvania. As a result of its new scale advantages, profitability is trending higher with a 28% operating margin against a 21% margin just four years ago. Earnings are expected to jump by 19% this year as the bank integrates branches and cuts costs.

But it isn’t just growth and profitability that should put it on your radar. This bank pays a dividend yield of 3.7% and trades for a price multiple well under the industry average.

Buy for Leadership, Stay for the Yield
FirstMerit Corp. (Nasdaq: FMER) was one of the few banks to escape the financial crisis without a quarterly loss and has taken advantage of industry weakness to grow by acquisitions. The regional bank closed its acquisition of Citizens Republic in 2013 and has doubled assets since 2007.

The bank’s net interest margin decreased slightly in the second quarter to 3.65% from 3.84% due to loans acquired in the Citizens Republic merger. This put pressure on the shares but should improve in coming quarters.

Loan growth grew 5.8% over the last year and should continue to strengthen on a rebounding economy this year and next. Revenue jumped 41% last year on the Citizens Republic acquisition and is expected to continue higher to $1.08 billion this year. Earnings growth of 19% this year is expected to cool somewhat but still post a 7.5% gain next year to $1.51 per share.

While the shares pay an attractive dividend yield, the quarterly payment has not increased since it was cut in 2009. Strong growth in earnings has driven the payout ratio to just 52% over the last twelve months versus an average of 61% over the last five years and a payout as high as 87% in 2004.

On expected 2014 earnings, the payout ratio would fall further to 45% and would be at the low end of the peer group. I do not see the bank allowing the payout ratio to fall much further, if at all. Even if the payout were raised to 50% of earnings, the annual dividend would be increased 10% to $0.70 per share.

While FirstMerit may not stand out as the hands-down leader in every metric, taken together the bank posts profitability and growth at the top of the pack. Shares trade at just 14.5 times trailing earnings, lower than the 15.9 times industry average and well below the company’s own average of 16.9 times over the last five years.

Risks to Consider: The shares already pay an attractive yield and management may not be pressured to raise the dividend immediately. Investors can feel confident in the company’s financial direction even if a dividend increase is pushed further out.

Action to Take –> On a price-to-earnings basis, shares of FirstMerit are relatively cheap and could go to $21.00 on 2014 earnings and a multiple closer to the industry average. Set a buy price up to $18.50 for this best-of-breed mid-size bank.

P.S. If high-yield banks pique your interest, my colleague Nathan Slaughter has found a high-yield investment that he dubbed “Private Banks.” There are only 44 of these investments. But they yield up to 12%, have beaten the market for the past five years and could protect you from the looming banking crisis. Get all the details in a free report, here.