Analysts at one firm suggest shares of Citigroup could double by the end of 2022.
Photo: Andrew Seng for The Wall Street JournalProfits at U.S. banks are tumbling, their stocks are underperforming and their executives sound grim. Their long-term investors are thrilled.
Value investors seek underappreciated companies, and they have spent a decade betting that the banks are stronger than they were going into the 2008 financial crisis. The market hasn’t agreed. While bank share prices were rallying through last year, sometimes hitting record highs, they were broadly unloved.
Compared with the overall market, bank stocks have traded at lower multiples of earnings and value since the financial crisis. They have been punished as if investors expect any economic trouble to expose underlying problems.
The solution, some investors believed, would be a new crisis to prove the banks can survive, in a more convincing fashion than annual practice stress tests have.
Enter the coronavirus pandemic.
No investor wished for a global pandemic, but the economic response to slow the spread of the virus looks like a laboratory-designed exercise to test bank survivability. The Federal Reserve slashed interest rates and has said it expects to keep them there for the next two years, which will hurt banks’ lending margins. Businesses and consumers are stressed, meaning outstanding loans look riskier. Executives have warned the outlook is bleak.
Bank stocks have plunged since the coronavirus hit. Still, the bank bulls point to signs of strength inside the second-quarter numbers. Quarterly profits were down almost across the board, for example, but they say the fact there was any profit at all is hopeful.
“If banks perform well in this crisis, it should inform the perception of their stability,” said Matthew Reed, portfolio manager for Fidelity Investments’ Select Financial Services and Select Banking funds. “That’s hard to prove out in good times.”
The bank bulls’ strategy runs counter to that of the many investors piling into stocks like Amazon.com Inc., Netflix Inc., Apple Inc. and Microsoft Corp.
The market rally since March has been driven by those tech growth stocks, particularly companies that seem to benefit from social distancing and stay-at-home orders.
At the same time, industries exposed to general economic growth, including banks and industrial companies, have been crushed. It is harder to judge the earnings power of those types of companies until investors get more clarity on the economy.
Those betting on banks have a different view: The banks, and particularly the big ones, have piled up so much capital and expanded their already-dominant positions since the last crisis that they are more immune to an economic collapse than before. These investors expect some pain but they think the market has overreacted, especially since they believe bank stocks were already undervalued before the coronavirus.
Banks and their investors point out that so far the banks have continued lending and eased the economic burden for borrowers—unlike the financial crisis, when they froze activity to preserve their own health. Randal Quarles, the Fed’s vice chairman, credited their increased strength in a July speech for helping the government and regulators.
“This has allowed the banking system to absorb rather than amplify the current macroeconomic shock,” Mr. Quarles said.
Investors and analysts admit there is still much uncertainty about the pandemic, but they are betting on sizable gains to come in bank shares.
Analysts at Oppenheimer & Co., for instance, say the earnings multiples of Citigroup Inc. C -1.59% and Wells Fargo WFC -1.87% & Co., which have fallen sharply, suggest their stocks could double by the end of 2022. JPMorgan Chase JPM -1.43% & Co., Bank of America Corp. BAC -1.23% and Goldman Sachs Group Inc. GS -1.14% could each rise some 50%.
For now, the crisis is still testing their bullish patience.
As U.S. companies tally the damage of the second quarter, banks are proving among the worst performers. The 18 banks in the S&P 500 index posted a median 77% decline in earnings-per-share from the prior year, according to FactSet. Analysts expect the entire S&P 500 index to post a 38% decline
Bank stocks also remain in the doldrums. The KBW Nasdaq Bank Index is down 34% this year while the S&P 500 is up a fraction.
The bank bulls see signs of strength. For example, the banks have put aside more in loan-loss provisions than any time since 2008 and are still expected to be profitable for the year.
Eric Hagemann, an analyst at Pzena Investment Management Inc., said the results show the banks are increasingly able to handle potential loan losses.
“Should the banks demonstrate such resilience, that could lead to a structural rerating of the stocks as they begin to be treated more like ‘normal’ companies,” he said. “They haven’t been treated like normal companies since the great financial crisis.”
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Other evidence showed the underlying value of bank assets increased in the second quarter. The average book value per share was up 7.4% from a year earlier, said RBC Capital Markets analyst Gerard Cassidy.
That important metric is one the bank bulls say is evidence the stocks could rally if there is more clarity about the economy and the virus.
The banks were trading at a median price-to-book value of about 84% in the quarter, down from 118% a year ago, Mr. Cassidy said. He is forecasting bank stocks will return to 110% of their book value.
“The time will come when everybody is going to jump into the banks,” Mr. Cassidy said. “Once people become convinced that the worst of the crisis is behind us, they will realize the banks survived.”
Write to David Benoit at david.benoit@wsj.com
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