'Quality' Bank Stocks Gain in Favor

Tickers in this article: BAC C CMA FITB KEY USB WFC

NEW YORK ( TheStreet) -- It may finally be time for bank-stock investors to favor quality names.

Until now, the big money has been made on shares of banks recovering from losses and a slowdown in lending.

The KBW Bank Index (I:BKX) is up 7% this year through Friday's close, following a 30% return in 2012. Last year's gain was heavily influenced by two major recovery plays: Bank of America (BAC) , which was up 110% after plummeting 58% in 2011, and Citigroup(C) , which rose 51%, following a 44% drop in 2011.

With the bank-stock rally continuing, this is a good time for investors to consider quality over recovery potential, as major players with strong earnings performance are trading for relatively low premiums to earnings estimates. Stifel Nicolaus analyst Christopher Mutascio said in a report Monday that "the market is allowing investors to purchase low-risk franchises with strong management teams that are generating profitability ratios well in excess of the industry's average at 'no extra charge.'"

Bank stocks are charging ahead, in part, because of the rapid rise in the yield on 10-year U.S. Treasuries. The Federal Reserve is planning to keep short-term rates at a record low until the U.S. unemployment rate improves to 6.5%. Some banks are poised for significant earnings improvement if this widening of the yield curve holds.

But some investors see the advancing yield on the 10-year benchmark bond as a sign that the central bank will move faster on raising short-term rates, which would cause a "parallel" increase in long-term rates and improve profitability for nearly all banks.

"The recent rally in bank stocks on the erroneous view that an increase in the 10-year U.S. Treasury yield is a significant driver of improved earnings or on the false notion that the Fed will raise short-term interest rates in the near-term has resulted in very little differentiation in the valuations between highly profitable banks and those that aren't as profitable," Mutascio wrote.

Bank of America and Citigroup, unlike the regional banks, are still trading at significant discounts to book value. Bank of America's shares closed at $11.76 Friday, trading for a relatively low 9.1 times the consensus 2014 earnings estimate of $1.29, among analysts polled by Thomson Reuters. Citigroup is at 8.1 times the consensus 2014 EPS estimate of $5.18, based on Friday's closing price of $42.68.

But the relatively low valuations for Bank of America and Citigroup reflect the high level of price volatility over the years, along with weak earnings. Bank of America's 2012 return on average assets (ROA) was 0.19% during 2012, according to Thomson Reuters Bank Insight. The ROA has ranged from a negative 0.09% to 0.22% over the past five years.