BNY Mellon is a Rock in a Euphoric Banking Sector

By Sean O'Reilly Markets Fool.com

Bank stocks have been on tear since the presidential election and in anticipation of the Federal Reserve increasing interest rates for only the third time since the financial crisis. Bank of America's stock has risen 49%, Goldman Sachs is up 30%, and even scandal-plagued Wells Fargo has climbed 23% -- all in anticipation of a more friendly regulatory and interest rate environment.

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After gains like these, however, it's important to focus on what could go wrong. So, for those looking to bet on stocks in the financial sector but want to avoid the current speculative fervor coursing through the markets today, read on to find out why TheBank of New York Mellon (NYSE: BK) is a great way to play the sector while protecting yourself against a major pullback should the current euphoria subside.

Recent results

BNY Mellon's fiscal year 2016 saw total revenue rise slightly from $15.19 billion to $15.24 billion, while earnings per share rose to $3.15 from $2.71, aided mainly by small loan loss provisions and cost cuts. A particular bright point is the bank's 21% return on tangible common equity last year.

Image source: Getty Images.

Total assets on the bank's balance sheet ended the year at $333 billion, while assets under management stood at $1.7 trillion, and assets under custody (an important measure because BNY Mellon is not a traditional bank, but primarily a custodial bank) ended the year at an all-time high of $30 trillion.

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A history of prudence

As one might imagine, it takes a great deal to accumulate custodianship of $30 trillion in assets. It goes without saying, then, that BNY Mellon has been a cornerstone of the U.S. banking industry. Its business model, and status as a custodial bank, also allowed BNY Mellon to survive the Great Recession.

True, this tried-and-true business model delivers what might be considered average returns on assets and equity -- averaging 0.77% and 6.49%, respectively, over the last decade -- but it becomes more attractive when one dives into measures such as return on tangible equity. In addition, the company has a plan to drive better returns in the years ahead.

Cost cuts, a unique advantage, and a compelling valuation

Let's face it, BNY Mellon is enormous. A trillion dollars is a gargantuan amount of money; acting as the custodian for $30 trillion is unimaginable. Which is why management is wisely focusing on efficiency to drive profits, with wider net interest margins to top it all off, in the years ahead. As highlighted in its latestquarterly earnings release, the company continues to trim risky real estate investments and invest in automation and technology solutions within its investment arm.

None of this should detract from BNY Mellon's competitive advantage in a world dominated by the likes of Bank of America and JPMorgan Chase. Its operational focus on off-balance sheet assets (read trust and custodial operations) as opposed to on-balance sheet assets (such as real estate loans) not only decreases the company's risk profile but allows it to operate under lower statutory capital requirements. In a world where banking continues to be heavily regulated, this model can be as dynamic as rocket fuel, as seen in the company's return on tangible common equity (after subtracting intangibles assets) relative to its peers:

Bank Return on Tangible Common Equity (2016)
BNY Mellon 21%
JPMorgan Chase 13%
Bank of America 9.5%

Source: Company regulatory filings.

All of these factors have analysts that cover BNY Mellon calling for respectable profit growth into the end of the decade:

Metric 2017 2018 2019
Estimated EPS $3.46 $3.88 $4.14

Source: S&P Global Market Intelligence.

With shares currently trading at around $48 each, giving BNY Mellon a forward P/E ratio of just 13.9, and a dividend yield of 1.6%, it's a compelling investment.

A few words of caution

Enterprising investors certainly aren't off their rockers for considering shares of BNY Mellon, or any bank for that matter, these days. Lending margins are expected to expand as the Federal Reserve raises interest rates and the regulatory environment eases. But we would be (lower case) foolish if we didn't impart a few words of caution.

The risks associated with BNY Mellon are more or less tied to the fact that the last time the financial industry increased its risk appetite in the mid-2000's, the 2008 financial crisis soon followed. It's hard to imagine a crisis of that magnitude popping up tomorrow, but that's just when one's guard needs to be up. Crises are always 20/20 in hindsight, and rare is the black-swan event that can be identified prospectively. If and when the global economy hits a bump in the road, BNY Mellon may very well suffer alongside its peers. However, it is due to this possibility that the New York-based bank is a gem in the banking sector itself.

Final takeaway

Banking may very well be "back," with a long runway of favorable regulatory treatment lying ahead of it. For Foolish investors looking for a safe way to play this trend, BNY Mellon should be on their radar.One can trust management to keep the ship steady, aided by pressure from outside investors. BNY Mellon may not produce eye-popping gains in the years ahead, as some of its more aggressive peers could, but the massive custodial bank is a solid defensive stock.Should a storm blacken the skies of the financial sector, its conservative balance sheet and status as a tried-and-true custodial bank will ensure that the nation's oldest bank will make it through without taking on too much water.

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Sean O'Reilly has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.