Why Bank Shares May Gain Fans As Economy Rises

Buyers are rushing back into bank and S&L; stocks, a sector of the market that had been mostly passed over in the August rally. If you like low price-to-earnings ratios and high dividend yields, this group remains a compelling idea for long-term investment--although there may be some bumps down the road.

The story on financial stocks hasn’t changed much over the last few months. Earnings overall are growing 10% to 15% year over year; bad loans continue to decline in most regions of the country and many banks are actively pursuing acquisitions to build market share. Meanwhile, dividend yields on many of the stocks are north of 3%, and bank dividend increases this year have been in the generous 10% to 12% range, on average.

But because this story has been driving bank stocks for so long (they rallied dramatically in both 1991 and 1992), by spring of this year Wall Street was focused more on what comes next--specifically, the expected rise in interest rates when the economy finally regains strength.

The rap on banks is that their profit margins typically move inversely to margins in other businesses: Banks make the most money, relatively speaking, when interest rates are falling, because deposit rates fall faster than loan rates.

When rates rise--a usual side effect of a hot economy--banks often find that their cost of money rises faster than they can raise loan rates.

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Investors tend to focus on the banking industry’s “net interest margin,” the spread between banks’ cost of money and what they earn on loans. In the first quarter of this year, that margin was a stunning 4.75 percentage points for the industry as a whole, according to bank stock specialist Keefe, Bruyette & Woods in New York.

The wide interest margin--which, if not a record, was close to it, analysts say--largely reflected the plunge in short-term interest rates to 30-year lows.

By April, however, Wall Street had begun to figure that the banks’ margins couldn’t get much better. So the stocks began to stagnate.

When Keefe tallied second-quarter bank earnings, it found that the industry’s margin had indeed shrunk. But it wasn’t by much: The second-quarter figure came in at 4.7 percentage points, Keefe analyst David Berry said.

Of course, short-term interest rates also have remained low; if and when the Federal Reserve decides to raise short rates, banks will inevitably feel it in the form of higher deposit costs.

But Berry noted that while banks’ cost of money would increase in a stronger economy, a pickup in growth also should mean greater demand for loans--a plus for bank profits. In fact, some borrowing is already rising: Consumer installment credit rose at a hefty 8.1% annual rate in July.

Does this mean bank stocks will ignore the initial rise in short-term interest rates, when it comes? Doubtful. But a study by market research firm Ned Davis Research found that bank stocks recover fairly quickly from the first shock of higher rates.

The study of 11 market cycles, back to 1965, looked at median stock industry group changes three months and 12 months after Treasury bill rates made their first move up. (The trigger used was a 23% rise in short rates.) The results:

* Major New York bank stocks were down 2% as a group three months after the rate rise, but 12 months later the stocks were up 8.5%.

* Regional bank stocks also dropped in the first three months after rates rose, for the most part. But they too were higher overall 12 months later. Western banks, for example, lost 1.2% in the first three months but were 13% higher a year later.

Admittedly, stocks in some other industries will rise much more quickly if the economy finally booms and interest rates rise. But buyers who are flocking back to the banks this week may figure it like this: Given the bank stocks’ cheap price-to-earnings ratios--and the chance that the economy and interest rates will stay in a slow-growth mode well into 1994--the risk in owning the banks today may be far lower than the risk elsewhere in the stock market.

Two ideas for mutual fund investors who want to play niches in the banking group:

* The John Hancock Freedom Regional Bank stock fund (phone: (800) 225-5291) is 75% invested in regional bank stocks (including First of America in Michigan, Union Planters in Tennessee and Union Bank in California) and 25% in S&Ls.; The fund is up 20% year to date.

* The Fidelity Select Home Finance fund ((800) 544-8888) is almost exclusively in S&Ls;, including many depressed California giants. So the fund in part offers a way to bet on a California economic recovery, for investors so inclined. The Fidelity fund also is up about 20% this year.

Bank Stock Redux

Bank stocks are on the rise again, after sleeping through much of the summer. A look at some analysts’ favorites, the stocks’ price-to-earnings ratios based on consensus 1994 earnings estimates, and the stocks’ current dividend yields:

Thurs. close ’94 Div. Stock (market) and change P-E yield BankAmerica (N) 48 3/8, + 7/8 9 2.9% Barnett Banks (N) 45 3/4, + 1/2 10 3.1% Chase Manhattan (N) 36 1/2, + 7/8 9 3.3% Citicorp (N) 35 3/8, +1 3/4 9 nil First Union (N) 47 3/4, +2 9 3.4% Hawkeye Bancorp (O) 20 3/8, - 1/8 11 2.2% Key Corp. (N) 39 5/8, + 5/8 9 3.1% PNC Financial (N) 30 3/8, + 1/2 9 3.8% Union Bank (O) 26 1/4, -- 8 5.3% Wells Fargo (N) 119 5/8, +3 3/4 11 1.7% S&P; 500 458, +1 16 2.7%

N--NYSE; O-NASDAQ

Source: Zacks Investment Research (earnings estimates)