Two Bank Stock Laggards

SmartMoney has article by Andrew Bary about two bank stocks that are lagging the rest of the banking sector. These stocks have been long term top performing stocks that are having a hard time with the current low short term interest rate environment. The Virtues of Slow and Sturdy

Two Laggards in the surging banking sector, Bank of New York Mellon and State Street, have some of the industry's best franchises, and should benefit from the inevitable rise in short-term interest rates.

Both look reasonably priced. BNY Mellon (BK), at 32, trades for 14 times projected 2010 profits of $2.34 a share while State Street (STT), at 48, commands 14 times estimated 2010 profits of $3.37 share. Both stocks trade for about 12 times projected 2011 earnings, well below their historic price/earnings ratios in the mid- to high teens.

Bulls argue that the stocks look appealing at a time when institutional investors are shunning defensive names in favor of more direct beneficiaries of a stronger economy. In the banking sector, turnaround stories are in vogue, including giants Citigroup (C), Bank of America (BAC), and regionals like Zions Bancorporation (ZION), SunTrust Banks (STI) and Regions Financial (RF), all of which were struggling with loan problems a year ago.

Financial stocks often face headwinds when rates rise, but BNY Mellon and State Street are part of a group of financials -- including discount brokers like Charles Schwab (SCHW) and TD Ameritrade (AMTD) -- that should get a boost from higher rates. BNY Mellon has estimated that a one-point rise in short rates would boost pretax profits by $500 million annually, or about 30 cents a share.

With the economy recovering and the stock market rallying, the Federal Reserve may start increasing short rates sooner rather than later this year. Near-zero short rates, for instance, have depressed profits in such areas as asset management and securities lending. BNY Mellon has been giving fee rebates to investors in short-term money-market funds that now yield next to nothing. Those rebates would decline as short rates rise.

"There aren't many dominant international companies that you can buy at these valuations," says analyst Eric Goldberg of Basswood Partners, a New York investment firm that owns BNY Mellon and State Street shares. "These are some of the highest-return businesses in banking, and their growth prospects are better than that of the typical commercial bank. It's almost unfair to compare them to banks." He puts fair value for BNY Mellon at about $52 a share and $80 for State Street.

The banks engage in similar businesses, as securities servicers and asset managers. BNY Mellon is the top global custodian, with $22 trillion of assets under administration. State Street is the No. 2 custodian, and its State Street Global Advisors is a leading investment manager, with $1.9 trillion in assets, including a strong position in exchange-traded funds. These custody businesses may not be exciting, but they benefit from oligopolistic market structures and prohibitive barriers to entry.

Disclosure: The Div Guy does not own shares of BK or STT at the time of this post.