The recent "stress tests" performed by the U.S. Federal Reserve on major banks had some unsurprising failures, including Citigroup. The tests also had one flop that analysts definitely weren't expecting – SunTrust Banks Inc. , an Atlanta-based company that had been widely viewed as being on the comeback trail.
You might think that SunTrust's surprising failure would reverse a rally that had seen the stock gain 50 per cent from its December lows. And yet SunTrust is up nearly 10 per cent since its stress test washout on March 13.
Surely, there's something wrong with the stress test. Or something wrong with investors.
Or maybe neither — meaning this supposed "failure" could be a smart way to bet on a U.S. economic recovery.
First, let's examine what actually went on in the stress tests. The Fed took a look at 19 major banking companies' financial statements in conjunction with their "capital action plans" — the dividend increases and share buybacks that they told the Fed they would like to engage in over the next few years.
The Fed then assumed an economic fiasco: Peak unemployment of 13 per cent, a 50 per cent decline in equity prices, and a 21 per cent decline in housing prices from already-depressed levels. All of this lasting for nine quarters.
Rather remarkably, 15 of the 19 companies came out of this scenario with capital levels above regulatory minimums. And in the aggregate, the 19 companies' forecasted capital levels were higher than they were during the 2009 financial crisis, the Fed said.
SunTrust, however, flunked the test. The Fed calculated that it would emerge from the hypothetical near-depression with a capital ratio of 4.8 per cent, beneath the 5 per cent required for a pass.
Its failure, though, was not as damaging as it might appear. SunTrust, in a delightfully circumspect announcement, noted that it passed the tests "without any capital actions" — which means that it was only the bank's undisclosed dividend-boosting and buyback plans, not its current state, that caused the problem. So SunTrust will keep its quarterly payment at 5 cents (U.S.) for the time being.
Gerard Cassidy, a banking analyst with Royal Bank of Canada's investment arm in the United States, illustrates what may have been: Before the stress tests, he had estimated SunTrust's 2012 dividend at 53 cents per share, rising to 96 cents in 2013. He now thinks that SunTrust's next "capital action plan" will be subdued enough for Fed approval and sees 32 cents in dividends this year and 47 cents in 2013. Mr. Cassidy also scaled back his 2012 and 2013 earnings-per-share estimates to $1.84 and $2.71, from $1.90 and $2.75, respectively, due to a smaller, but nonzero, level of share repurchases.
So, with per-share earnings and dividend payouts in retreat, is a SunTrust recommendation crazy talk? Hardly. Even after its remarkable gain in the last three months, SunTrust is trading about one times its tangible book value. (Tangible book value takes out intangible assets like brands and goodwill and also treats preferred stock like debt, instead of equity.)
Right now, many of its "super-regional" banking peers are trading at 1.4 times tangible book value, notes analyst Terry McEvoy of Oppenheimer & Co. Inc. According to Standard & Poor's CapitalIQ, SunTrust averaged a 2.5 times price-to-book ratio over the 15 years leading up to the financial crisis, never falling below a yearly average of 2.0.
Its current bargain-basement valuation reflects the risk that SunTrust will have to repurchase more residential mortgages than expected. Major U.S. lenders that packaged mortgages into securities have been dealing with investors who have demanded they be bought back, citing the original investment agreements. SunTrust CEO called the process "frustrating" and "increasingly difficult to predict" in a December meeting with Wall Street analysts.
However, a footnote in SunTrust's 10-K annual report suggests the number ultimately could come in below expectations, says analyst Robert Patten of Morgan Keegan.
With nearly 1,700 offices and $172-billion in assets, primarily in the U.S. Southeast from Maryland to Florida, SunTrust seems well positioned for a rebound. Mr. Cassidy of RBC has a $30 target price on the stock, now trading at $24. "SunTrust is our 'risk-on' stock for the recovery in the U.S. economy and housing markets," he says.
So while SunTrust might have flunked the Fed's stress test, it may pass your portfolio test if you're bullish on our southern neighbour.