January 24, 2011

2010 Q4 Earnings Analysis: Portfolio Managers Weigh Banks’ Performance

Companies’ success draws closer scrutiny of individual performance

As fourth-quarter 2010 results come in, portfolio managers who invest in the finance sector are finding that they’ve got a lot of homework on their hands.

Now that a number of banks and brokers have reported Q4 earnings—including Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Schwab, TD Ameritrade and Wells Fargo—portfolio managers are taking stock of the sector’s fortunes. And they’re finding that due diligence is taking on a deeper meaning as individual company performance assumes a greater role than it might have done during the financial crisis.

“With results coming in better than expected, investors are asking what drove the results. Is it fundamentals? Is it lower expenses? People are really diving in, and in the bull market, people are parsing earnings in a way that they hadn’t before because stocks were cheap in general,” said Tim Holland (left), a portfolio manager with the Aston/TAMRO Diversified Equity Fund, which invests in some of the financial services firms that reported earnings last week, including Raymond James, Goldman Sachs and JPMorgan.

M&A, Diversification, Fees Should Drive Growth

Q4 2010 results show the finance sector has re-established itself—and that means individual companies can expect to be more closely studied for their unique take on growth. Those that use pent-up capital to do merger and acquisitions should fare better with investors than ones that remain mired in regulatory issues. Diversified firms have a better chance of generating new revenue streams, and firms that find ways to pull in more fees to compensate for low interest rates should do well.

“Investors are being much more discriminating in terms of the numbers,” Holland said. “Results have come in better than expected, but there are different things driving those results. And now people are focusing on growth.”

Last year’s data had led investors to believe that large banks would underperform in the fourth quarter, which helps explain why this earnings season has so far delivered so many surprises to the upside.

In 2010 the KBW Bank Index of 24 exchange-listed large and regional banks outperformed the S&P 500 index, with the former returning 22.2% versus the latter’s 12.78%, according to Anil Lalchand, a co-director of credit research who covers banks and the financial industry at DoubleLine Capital LP.

“The higher return for the KBW Bank Index in 2010 was mainly driven by the strong performance in the regional banks,” Lalchand explained in an email. “However, if we look at just the large banks such as JPM (1.8%), Goldman Sachs (-0.40%), Morgan Stanley (-8.07%), Bank of America (-11.42%) they clearly underperformed. Wells Fargo (14.82%) outperformed slightly but the clear winner was Citigroup (42.90%).”

Stocks Have Longer Way to Go in 2011 Than Bonds

So how should portfolio managers and advisors adjust their positions this quarter?

“There is more improvement to come on the equities side for banks, certainly more than there is for the credit side,” said Bonnie Baha (left), head of the global developed credit group at DoubleLine. “For financial sector bonds, there will be more improvement, though it won’t be as dramatic as the improvement we saw in 2010.”

Although DoubleLine is currently overweight the financial sector in its portfolios and believes there is “more juice left in the orange,” a lot of the wins really came

in 2010 in terms of credit spreads, Baha noted. “Credit spreads for the sector in the investment grade and high yield markets tightened in much more than anything else, including industrials, utilities and sovereigns. We’re coming off a year of very good performance.”

As for stocks, in 2011 they will be closely tied to the overall business environment and the willingness to make loans, Baha predicted. “Citigroup looks interesting. They are out from under the government’s bailout wing, and have a big global footprint to pursue consumer lending overseas.”

Compare Citigroup’s dynamic position to Bank of America, Baha added, which is still digging out from under mortgage issues related to its acquisition of Countrywide Financial.

Results for Citigroup, Goldman Sachs and Morgan Stanley have come in better than expected, but the share price performance has been mixed, noted Aston/TAMRO’s Holland. The issue of proprietary trading continues to weigh on Goldman Sachs and Morgan Stanley as they struggle through implementing the Dodd-Frank’s Volcker rule.

However, Goldman, Morgan Stanley and JPMorgan are all returning to their pre-crisis strength in investment banking, Baha said.

Expect to See a Pickup in LBOs

“I think the brokers are probably performing better simply because we’re at that point in the business cycle where investment banking could generate fee revenue for them,” she said. “We expect to see leveraged buyout activity pick up. That’s going to put a smile on the face of investment bankers on Wall Street.”

As for the smaller firms, Raymond James “was very aggressive in its advisor recruiting efforts,” Holland noted, adding that companies such as Raymond James that were able to invest in the last couple of years are reaping the rewards now. Firms that can afford to get active in M&A in 2011 will do well, he said.

Schwab and TD Ameritrade, on the other hand, are weighed down by low interest rates, Holland said, and they are losing money on a lot of their money market account businesses.

The big takeaway is that banks with greater diversification, like JPMorgan and Wells Fargo, are in the strongest position. “They have multiple revenue levers that they can press on, so investors are more enthusiastic about those banks,” Holland said.

“JPMorgan is always the jewel in the crown,” Baha agreed. “They have such diverse lines of business and great management.”

To be sure, one such revenue lever is the commercial and retail bank’s ability to charge customers fees, especially in this slow period for loans.

“Banks are being forced into being more creative about how they will generate revenue,” Baha said, pointing to JPMorgan CEO Jamie Dimon’s widely quoted comment last year that “if you’re a restaurant and you can’t charge for the soda, you’re going to charge more for the burger.” 

Read “2010 Q4 Earnings, Week One: Banks May See 30% EPS Growth, Says Analyst”  at AdvisorOne.com.

Read AdvisorOne's 2010 Q4 earnings calendar for the financial sector for release dates and links to earnings stories.

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