Income investors have been so focused on traditional high-dividend low-volatility stocks (like utilities and REITS, which are currently carrying very rich valuations) that they are overlooking the increasing attractiveness of some big bank stocks. Over the last week, we received good news from the Federal Reserve’s “stress test,” yet many of the banks have underreacted (perhaps due to Brexit fears and a lingering fear left over from the financial crisis). In particular, we like M&T Bank. It pays a big dividend (2.4% yield), and it has the ability to continue growing the dividend beyond what already happened this week.
This week, M&T Bank was a big winner in the Fed’s stress tests as it was approved to pay out more than 100% of earnings as dividends and share buybacks. According to the Wall Street Journal, “M&T Bank’s initial capital-return request was so ambitious it was the only bank to revise its request downward when two capital ratios initially fell below the Fed’s minimums. The bank’s modified request, approved by the Fed, was still much more aggressive than analysts expected and called for paying out up to 120% of earnings to investors. Analysts had estimated it at 84%.” [M&T’s payout was so high because it has accumulated capital over a period of more than three years in which it waited for the Fed to approve its purchase of Hudson City Bancorp Inc. This year’s outcome is the first stress-test result since that deal closed last year].
Yet, as the following table shows, M&T’s shares continue to consistently under-perform the S&P 500, as do many other financial stocks.
Total Returns as of 6/30/2106
Worth noting, M&T also has an attractive price to book ratio. Specifically, it’s above one suggesting they don’t have the same level of high risk distressed assets of many of the other systematically important banks. Yet by historical standards, a 1.2x price to book is low, signaling the price has room to increase via multiple expansion. Also critically important, M&T’s return on capital exceeds its cost of capital. This means they create value with every new dollar they invest. Many other banks are not able to do this.
Valuation:
A basic dividend discount model suggest M&T is worth $27 billion or more than 30% more than its current share price. To arrive at this figure, we took the average 2017 analyst earnings estimate ($9.07 per share times 159 million shares) and assumed an 80% dividend payout ratio (remember, the Fed has just approved the company for a big payout ratio increase). We also assumed a 7.425% cost of equity (using the reasonable assumptions at Guru Focus). And then we discounted the 2017 earnings by the cost of equity minus a very conservative perpetual growth rate of 3% (analyst expect a much higher rate of 8.61% over the next five years).
Management:
Another reason we like M&T is the strong management team. The leadership has a track record of completing exceptionally valuable acquisitions. They also have very strict underwriting standards. And very importantly, management owns a large portion of the bank thus aligning their interests with shareholders.
Risks:
Like all businesses, M&T faces risks. For example, the company runs the risk of not being able to successfully complete acquisitions as they’ve done in the past which could increase costs and reduce profitability and dividend growth.
Another risk is obviously interest rates. Low rates compress the net interest margin (and profitability) across the banking industry. We happen to believe now is an attractive entry point because rates have just experienced downward pressure following Brexit, and we expect rates to rise going forward, but there is no guarantee that rates will ever rise significantly and low rates could continue to hamstring M&T Bank.
M&T's is trying to grow in competitive markets. Specifically, M&T is trying to grow in New York and Washington DC metro areas where there is already lots of competition. This could create challenges that M&T is not used to, and it could dampen results relative to expectations.
Conclusion:
Overall, we believe M&T Bank is currently offering a very attractive investment opportunity for income-focused investors because its dividend is already large and will continue to grow, and because the bank is very safe (thanks to increased regulations following the financial crisis), especially relative to other big banks. We believe the price of M&T is lower than it should be because the banking industry has such a bad reputation after the financial crisis, and many investors are not realizing that many of those risks are now in the rear view mirror, and the overall industry (especially M&T Bank) is increasingly safe. Further, relative to other income options, banks (and M&T in particular) are increasingly attractive. We do not currently own shares of M&T Bank, but we are watching it closely and may purchase shares in the future.