Sunday, February 23, 2014

Are Profit Margins Mean Reverting?

Over the past couple of years, many readers have messaged me to ask about good blogs to read.  As I have said before most everything you read on the internet is useless and often repetitive.  Original ideas and thoughts are rare. 

That said, I stumbled upon a blog a few weeks back called Philosophical Economics and found it to offer interesting perspectives on many investment issues.  The author of the blog often challenges the status quo and provides unique thoughts that are contrary to many conventional wisdom.  Ideas are also well supported with evidence and not just conjecture. 

In a recent post the author questioned the commonly held idea that profit margins are mean reverting and bound to fall from currently elevated levels.  I thought the arguments were interesting enough to share, so here is a link:

http://philosophicaleconomics.wordpress.com/2014/01/10/cape/

As I've said before, unless you understand both sides of an argument you really don't understand anything.  There are intelligent people on both side of every debate and to simply write off the opposite side without thoroughly understanding their position is quite dangerous.  With that said, you still don't have to agree with one side or another but it should allow you to better defend whatever position you take. 


Best Regards,

Kevin

Saturday, February 15, 2014

Bank Dividend Increases & 2014 CCAR

Historically the banks have released their capital plans mid March, so we are approximately one month away from finding out the results for 2014.  This process is often called the Comprehensive Capital Analysis and Review (CCAR).  All bank holding companies over $50 billion in assets are required to submit their capital plans for review.  I thought I provide a few details on what I am looking for from the banks as I am a shareholder in a few of them. 

Over the past 4 years the banks have been building fortress balance sheets.  Under the new capital rules, called Basel III, banks are require to hold more capital against risk weighted assets.  The new rules also require a surcharge for Systemically Important Financial Institutions (SIFI), or banks that are too big to fail.  This surcharge ranges from 1% to 3.5% depending on the institution.  WFC requires 1%, BAC requires 1.5%, and both C and JPM require a 2.5% buffer.

While these additional capital requirements are being phased in over time, most of the US banks have set out to meet them today.  Full requirements are not required until March 31, 2018.

So where do the banks sit today? 

Wells Fargo

WFC has met their 1% SIFI buffer, which is an additional $12.9 billion in capital.  In addition to meeting this buffer, WFC has $22.9 billion above that level.  They are generating about $22 billion in capital per year and have been paying out approximately 30% of that in dividends, or $1.20/share ($6.8 billion).  I would estimate that they raise their dividend to around $1.60-$1.80/share ($9-10 billion) and have authority to buy back $5 billion in stock. 

Bank of America

BAC is required to hold an additional 1.5% SIFI buffer.  This is an additional $19.3 billion in capital on a fully phased in basis, a 8.5% tier 1 capital requirement.  They have already met that buffer and have an additional $19.9 billion in capital above that amount (9.96% Tier 1 Basel III).  They are in decent shape among the big banks.  Currently BAC pays a $0.04/share annual dividend, or one cent per quarter ($400 million/year).  They are currently generating about $12 billion in capital per year, but are still under earning their potential.  I would estimate they return $5 billion in dividends this year, or around $0.40/share, and up to $7 billion in share buybacks.  If they leaned toward doing more buybacks verses increasing the dividend I also wouldn't be surprised. 

Citigroup

Citi is the next strongest bank with respect to capital.  Citi is required to hold an additional 2.5% SIFI buffer, amounting to $30.0 billion.  They have met this amount and have an additional $11.7 billion above the buffer.  Like BAC they pay almost no dividend at $0.04/share annually ($120 million).  Citi is currently generating $12 billion in capital per year and also under year earning their potential.  I would estimate they return $5 billion in dividends this year, or around $1.60/share, and another $5 billion in share buybacks.  If they leaned toward doing more buybacks verses increasing the dividend I also wouldn't be surprised given their low stock price.  It would be the intelligent thing to do.  Citi also has a pile of deferred tax assets (DTAs) that greatly reduce their Tier I capital under Basel III (to the tune of $43 billion).  This is really a huge buffer and will lead to huge capital returns in the future. 

JP Morgan Chase

Lastly, JPM requires a 2.5% SIFI buffer, which amounts to $39.8 billion.  They just barely met this fully phased in requirement  last quarter and have nothing above that buffer.  This puts them in the weakest position from a capital standpoint but keep in mind that these requirements do not need to be met for another 4 years.  JPM is currently generating around $22 billion in capital annually.  They pay $1.52/share in dividends per year ($5.8 billion), and were approved for a $6 billion buyback last year.  Look for JPM to return $7.5 billion in dividends or $2/share and buy back $6 billion in stock this year. 

Conclusion

I'm really looking forward to the CCAR results as the banks have rebuilt themselves and are in a position to begin returning large amounts of capital to shareholders.  This trend will continue for a number of years as the banks are over capitalized and some have significant DTA's and other capital deductions, mostly C and BAC.  This gives an additional buffer to shareholders and will allow for increasing capital returns over time.

As a shareholder I would prefer capital returns sooner than later but it doesn't really matter when it is returned since it's all money in the bank.


Best Regards,
Kevin


Disclosure: Long WFC, BAC class A warrants, & JPM warrants.