Many investors have been caught off-guard in the ongoing bear market and thus wondering how they should position their portfolios. The surge of inflation to a 40-year high exerts great pressure on the margins of many companies, but a few sectors actually benefit in the current environment.
To be sure, banks greatly benefit in the current environment of rising interest rates as they enjoy much wider net interest margins, i.e., the difference between the interest they charge on their loans minus the interest they pay on their deposits.
Below we discuss the prospects of three banks that are offering dividend yields above 4%.
Plug In This USB
U.S. Bancorp (USB) was founded in 1863 and has grown from a regional bank to a national powerhouse in recent years, becoming the fifth-largest bank by assets in the U.S. It focuses primarily on traditional banking activities, but also offers wealth management, payment and investment services.
The primary competitive advantage of Minneapolis-based U.S. Bancorp is its exceptional performance record, which has resulted mostly from its exemplary management team. The company operates as a regional bank, but on a massive scale, and hence it has proved much stronger during recessions than its larger peers. Indeed, while many banks were struggling to survive during the Great Recession, the earnings of U.S. Bancorp decreased less than 50% and the bank emerged much stronger from that recession than most of its competitors.
It is also important to note that U.S. Bancorp grew its earnings per share every single year since 2009, until the pandemic struck in 2020. This is an exceptional performance record. The bank has grown its EPS by 6.7% per year on average over the last decade. While U.S. Bancorp will find it hard to match its record earnings per share of $5.10, which were posted last year, it is still on track for its second-best performance in its history this year.
Moreover, as U.S. Bancorp is more focused on traditional banking services, it benefits more than many banks from rising interest rates. As long as interest rates remain high, U.S. Bancorp will continue thriving.
Furthermore, U.S. Bancorp has raised its dividend for 11 consecutive years and is currently offering a 4.4% dividend yield. Given its healthy payout ratio of 44% and its proven resilience to downturns, the bank is likely to continue raising its dividend for many more years. The company has grown its dividend by 10% per year on average over the last decade and over the last five years. Given all these characteristics, it is evident that U.S. Bancorp is an attractive candidate for income-oriented investors.
A Dividend Ally
Ally Financial (ALLY) provides financial services to consumers, businesses, automotive dealers and corporate clients. Its services include term loans, lines of credit, fleet financing, vehicle financing and commercial insurance products. It is also remarkable that the offerings of the bank attract many millennials. This bodes well for the growth prospects of the company.
Ally Financial was bailed out during the Great Recession. Following the bailout, the company went public again in 2014 and hence it has a short history record. Its bankruptcy in 2009 and its short performance record increase the inherent risk of the stock.
On the bright side, Ally Financial has significantly grown its earnings per share, from $1.36 in 2014 to an expected $6.00 per share this year. Just like U.S. Bancorp and Citigroup (see below), Ally Financial posted record EPS of $8.60 in 2021 thanks to the strong recovery of the economy from the pandemic and the resultant reversion of loan loss provisions. As this tailwind is non-recurring, the bank is not likely to be able to match its record performance anytime soon.
On the other hand, Ally Financial greatly benefits from the aggressive interest rate hikes implemented by the Fed, as this policy enhances the net interest margin of the bank. This is clearly reflected in the results of Ally Financial, which is on track for its second-best performance this year.
It is also worth noting that Ally Financial is exceptionally shareholder-friendly, as it is offering a generous dividend yield of 4.6% while it is also repurchasing its shares at a fast pace. Since 2014, the bank has reduced its share count by 4% per year on average. In addition, the stock is offering a nearly eight-year high dividend yield with a solid payout ratio of 20%. Therefore, its dividend seems to have a wide margin of safety in the absence of a prolonged recession. Nevertheless, investors should always keep in mind that this bank is vulnerable to economic downturns.
Go to the Citi
Citigroup (C) was founded in 1812 and has grown into a global juggernaut in credit cards, commercial banking, trading and a variety of other financial activities. Citigroup is not as tied to traditional lending as most other banks. Its competitive advantage lies in its global reach and its large position in the lucrative credit card business.
Citigroup would be a much larger bank but it incurred excessive losses in the Great Recession, the worst financial crisis of the last 90 years, in 2009. The bank was caught off-guard in that crisis and had to restructure. As a result, its shareholders incurred devastating losses. To provide a perspective, the stock has recovered from its bottom in that recession but it is still trading approximately 90% below its pre-crisis levels, in 2007.
Fortunately, Citigroup seems to have learnt its lesson from that recession. Thanks to the favorable business environment for financial companies, Citigroup is on track to post EPS of about $8.20 this year. This will mark its second-best performance since the Great Recession.
Its best performance was in 2021, with earnings per share of $10.07, but it will be hard for the company to repeat such performance given the excessive non-recurring loan loss reversions recorded in that year thanks to the recovery of the economy from the pandemic. Nevertheless, if Citigroup meets our expectations this year, it will have grown its EPS by 7.8% per year on average over the last decade. This is certainly a satisfactory growth rate, though investors should be aware that there is significant volatility in the performance of the bank.
As long as interest rates remain relatively high and the economy does not fall into a severe recession, Citigroup is likely to keep thriving thanks to the aforementioned effect of high interest rates on the margins of the bank. On the other hand, the company is likely to have a hard time growing its earnings off this year’s high comparison base. Nevertheless, the market has already priced this in the stock, which was recently trading at an exceptionally low price-to-earnings ratio of 6.0, a nearly 10-year low level.
Moreover, Citigroup is currently offering a 4.2% dividend yield. The company has kept its dividend constant for three consecutive years so it passes under the radar of most income-oriented investors. On the other hand, it has a payout ratio of only 25% and hence its dividend has a meaningful margin of safety for the foreseeable future.
The surge of inflation this year has put numerous companies under pressure due to the resultant increased costs and the impact of rising interest rates on the interest expense of most companies. However, as long as a severe recession does not show up, banks seem to be a bright spot, as they enjoy much wider net interest margins, which more than offset the effect of rising provisions for loan losses.
The above three banks are currently offering above-average dividend yields, with a material margin of safety. Among the three banks, U.S. Bancorp seems to be the most attractive one thanks to its exemplary management, its solid performance record and its superior resilience during economic downturns.