For Investors In Bank Stocks, Profit, It Seems, No Longer Matters

Analysis

Traders at the New York Stock Exchange on Wednesday, as the market dumped on Bank of America.
Traders at the New York Stock Exchange on Wednesday, as they dumped on Bank of America.

Traders
Traders at the New York Stock Exchange on Wednesday, as they dumped on Bank of America.

Given the rash of banking scandals over the past few months, it might not come as a surprise that media pundits, politicians in various continents and regular citizens across the world have little trust in any numbers big bankers might present them.

What might be a surprise: investors seem to be losing faith in banks too, disregarding the parade of fat, better-than-expected profit figures major financial institutions have reported over the past few days and instead using top-of-the-line revenue and return on equity numbers to guide their investment decisions.

Since the current earnings season -- the six-week period where most public companies traded in American markets report quarterly results -- began, and counting until Wednesday, 17 financial institutions in the S&P 500 have released their latest three-month financial tally. Among big banks that already have reported are New York-based banking giants JPMorgan Chase and Co. (NYSE:JPM) and Citigroup Inc. (NYSE:C), investment bank Goldman Sachs Group (NYSE:GS), and broker Charles Schwab (NYSE:SCHW). Twelve of the 17 houses of finance have had better-than-expected profit numbers.

Yet in spite of the surprisingly good earnings, only a handful of those companies, like credit-card issuer Discover Financial Services (NYSE:DFS) and commercial banker M&T Bank Corporation (NYSE:MTB) have significantly outperformed the market.

The
The correlation between earnings surprise for certain large public financial companies and stock performance two days after financial results are released has been close to 0, as this scatter chart demonstrates.

An analysis by the International Business Times shows that, indeed, the market has basically disregarded headline beats on earnings -- that is, cases where the earnings per share reported by companies exceed analyst expectations. The correlation between the percentage earnings surprise, as calculated by Thomson Reuters for the 17 financial companies, and better-than-average performance for those companies' shares in the stock market, has been close to 0.

In stark contrast, the correlation between the percentage of a surprise on revenue above or below what analysts were expecting, and performance of any specific company's shares in the stock market has seen more robust correlation, with issues outperforming the wider stock market by 0.27 percent, on average, for every 1 percent the revenue reported in quarterly financial releases beat consensus expectations.

By
By contrast there has been a robust correlation between revenue surprise results and stock performance.

The divergence between earnings beat percentages and stock market underperformance has been driving the pattern, and has been stark for some ticker symbols. Shares of asset manager BlackRock (NYSE: BLK) and credit-card issuer American Express Co. (NYSE: AXP), both of which exceeded analyst expectations on earnings but had underwhelming sales figures, dropped in the period following earnings, with stock in those companies underperforming the wider market by 0.96 and 5.11 percent, respectively. Bank of America Corp., which beat analyst earning expectations by a whopping 24 percent -- but missed on revenue -- has seen a sharp sell-off, with shares underperforming the S&P 500 by 9.27 percent.

Investors' disregard for earnings beats is better understood as an assessment by investors that while financial companies were able to wring out more profit out of their operations than expected, earnings got squeezed out of lower loan-loss provisions, accounting gimmicks and cost displacement strategies, not real loan book growth. Lackluster return-on-equity, or ROE, figures, which measure bank profitability when compared to held assets, have been a common theme among equity analysts.

The beat was generally low-quality in our view ... results were OK under bad conditions, but we don't see the backdrop improving anytime soon and mid-single digit ROEs should continue, analysts at JMP Securities said in a note to clients about Bank of America's results.

In the case of American Express, analysts had divergent opinions as to what the earnings beat really meant, with the pessimists eventually taking the day by portraying it as earnings achieved on the back of cost-cutting that still could not hide deceleration of billed business as a result of weakening global spending trends, as analysts at Guggenheim Securities wrote in a note to clients.

On the opposite end of the spectrum as Bank of America and American Express, large retail banks M&T Bank Corp. (NYSE:MTB) and Comerica Inc. (NYSE:CMA) reported robust revenue beats and strong interest in loans.

Unlike some of his bank chief finance officer peers, when Rene Jones of M&T spoke to analysts after results were released and talked about  how they still have a lot of work to do, he meant it in the sense of competing for business, not laying off employees or re-structuring organizations. M&T outperformed the market after earnings by 2.62 percent.

It seems likely the trend of financial institutions outperforming as investors look at top-of-the-line instead of net profit metrics will continue. Wednesday, for example, Capital One Financial (NYSE: COF) reported earnings that missed analyst expectations by 88 percent on huge charge-offs related to acquisitions and legal settlements but still pegged revenues 30.8 percent higher than analysts had expected. The stock soared, climbing over 6.5 percent before settling up 2.7 percent and handily beating wider market returns.

(Capital One was not included in the International Business Times' correlation analysis, as there was only one trading session after earnings as of pixel time. All correlation was calculated taking into account at least two consecutive trading sessions.)

Goldman
Goldman Sachs, with poor profitability metrics in spite of beats of both revenue and earnings, saw a the market deliver its comeuppance.

Not all bank stocks have followed the pattern seen in the correlation neatly, of course. But it seems even the exception proves the pattern. One of the biggest outliers was Goldman Sachs Group, which beat analyst expectations on both revenue and profit, but still saw shares underperform the S&P 500 by 2.61 percent.

Unfortunately for Goldman, investors disregarded both those numbers as essentially meaningless, and instead focused on the dismal return-on-equity figures, which at 5.4 percent, are less than Goldman's cost of capital.

Upcoming companies that will test the validity of the trend include large commercial banks SunTrust Banks (NYSE: STI), Zions Bancorp (Nasdaq: ZION) and Regions Financial Corporation (NYSE: RF), asset manager Invesco Ltd. (NYSE: IVZ) and broker E Trade Financial Corporation (NASDAQ: ETFC), all of which are set to release earnings in coming days.

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