I recently wrote a column about the rather frothy technology sector, offering up three overbought tech stocks and two that were still bargains. But another sector that investors are undoubtedly watching right now is the financial industry. With some of the biggest names in banking posting market-trouncing returns in 2012, traders could be getting ready to pull the trigger and take their profits off the table.
Admittedly, in the short term the upside may be limited for many banks. The breakneck run since Thanksgiving — about 30% for the diversified Financial Select Sector SPDR ETF (NYSE:XLF) — hints you’re going to be pretty late to the train if you’re investing right now.
However, while there are some dogs with fleas that appear to be bid up simply through naïve optimism, I think a few very strong bank stocks would make excellent long-term buys and are worth holding onto — or buying during a pullback.
The biggest difference between the financial stocks to keep and the financial stocks to dump? Well, the losers are divesting assets and still on the defensive, while the winners are in growth mode and clearly focused on acquisitions or building shareholder value.
Here are two stocks to buy and two stocks to sell in the financial industry.
Financial Stock to Buy: JPMorgan
JPMorgan has, in some respects, come out of the financial crisis as an even better financial institution than when it went in. JPM stock has reclaimed the $45 mark — challenging levels not seen since 2007, while rival Citigroup (NYSE:C) have a five-year return of -90%. JPMorgan Chase surpassed Bank of America (NYSE:BAC) last year as the largest U.S. bank by assets, thanks in part to Dimon’s fire-sale purchases of Bear Stearns and WaMu during the meltdown.
And with the recent approval from the Federal Reserve, JPMorgan has become a decent income play once again — with 30 cents paid quarterly for a 2.7% yield. That’s the best dividend yield among the biggest banks, and light years ahead of Citi and BofA, which pay a mere penny a quarter.
JPMorgan certainly has risks, as do all financial stocks going forward. Regulations such as the Volcker rule and higher capital requirements will affect earnings. Banks generally make profits on the difference between the rates they pay on deposits and the interest they charge on loans, and low rates mean that spread is squeezed very small right now. And let’s not forget the very real threat of another credit crisis if European sovereign debt woes continue to drag on.
But JPM has a healthy balance sheet and will outlast any short-term headwinds. When the economy inevitably recovers, this financial stock will be there to capitalize. Revenue is already above fiscal 2008 levels — with earnings forecasts of $4.46 this fiscal year, after EPS of just 84 cents in fiscal 2008.
Be cautious, because the 34% run-up year-to-date gives me pause. But an entry around $40 a share seems like a bargain for long-term investors. Shares dipped below that mark briefly for a few periods in 2011, but never stayed there long.
Financial Stock to Sell: AIG
Whether it’s part of your portfolio or not, as a dutiful U.S. taxpayer, you technically already own one-time insurance giant American International Group (NYSE:AIG), thanks to the TARP bailout. According to the U.S. Treasury and its regular TARP updates, you still do. About $37 billion of nearly $68 billion disbursed to AIG remains outstanding — with almost $4 billion in losses already realized on Uncle Sam’s “investment.”
But forget the politics for a second, if you can. Let’s discuss the fact that investors who bought AIG around Thanksgiving have been rewarded with a 40% profit in this stock — almost triple the market.
So will the run continue? Fat chance.
Admittedly, in February, AIG reported a whopping $19.8 billion profit for its fourth quarter. But here’s the catch: Approximately $17.7 billion of that profit is just a trick of the spreadsheet due to tax benefits. Sad but true — bailout baby AIG is sticking it to taxpayers twice!
The “bargain” P/E of around 4 is a mirage, based on earnings that are a trick of the spreadsheet.
Furthermore, AIG continues to hold stock offerings and divest assets to get out from under TARP — including the continued sale of assets in its Asia operations, primarily the AIA Group. The company is mortgaging its future to repay debts, and that’s not a growth plan.
AIG may find its way eventually, but you shouldn’t be part of the risky journey out from under TARP. After a 40% run in a bit more than four months, it’s time to take profits off the table. Sell AIG.
Financial Stock to Buy: Capital One
I have to give credit to bank analyst Philip van Doorn on this one. He pitched Capital One Financial (NYSE:COF) as a great stock months ago, and it has tallied a nearly 30% gain year-to-date and continues to show momentum.
Philip’s reasons are shared across many financial stocks: Improving earnings and low valuation when it comes to price-to-earnings and price-to-book ratios. Specifically, COF has posted improving year-over-year earnings in eight of the last nine quarterly reports, boasts a forward P/E of 8.1 based on fiscal 2013 numbers, and a price/book of 0.85. A company that is still priced at just 85% of its book value even after this kind of run-up certainly is worth a look.
Of course, investors are very skeptical of bank earnings and valuations — so those reasons alone aren’t worth jumping in. But like JPMorgan, some bargain acquisitions have also been baked into Capital One lately that I think bode very well for future growth.
First there’s the purchase of the U.S. operations of ING Group (NYSE:ING) for roughly $9 billion. Some consumer groups gathered in opposition, but in February the Federal Reserve gave its approval for the marriage. Then there’s the deal to acquire the U.S. credit card portfolio of HSBC Holdings (NYSE:HBC) for $2.6 billion, approved just earlier this month.
Both of those areas are going to significantly add to Capital One’s footprint and growth potential.
Admittedly, the fact that Capital One did not ask for a dividend increase or share buyback after passing the recent round of stress tests is a bit of a downer. But I am convinced that tying up cash in buyouts will be a better long-term use of cash.
The “smart money” seems to agree. In fact, Jeffries & Co. just put a buy rating on the stock on March 19 — with a target of $72.
As always, beware of buying a top after a rally like this. But long term, I think COF will serve investors well.
Financial Stock to Sell: Citigroup
The Federal Reserve’s Stress Tests are kind of like the SATs: a decent measure of potential, but certainly not the last word on where the test-taker will be 10 years from now.
But it’s safe to say that as imperfect as the methodology is, a failing grade should always set off warning bells. Thus, investors should run screaming from Citigroup (NYSE:C) — especially after a very frothy run-up of 50% since Thanksgiving.
Citi didn’t meet the 5% “Tier 1″ capital requirement of the Fed — and let’s be honest, there are certainly clouds on the horizon that would justify the need for a rainy-day fund. From geopolitical unrest in the Middle East to the Greek debt crisis, it’s not hard to imagine another “shock” to the global economy in the near future.
Furthermore, while other banks like Capital One and JPMorgan are making strides to advance their sales and earnings, Citi remains below pre-2008 levels. What’s more, fiscal 2011 earnings and revenue were significantly on the decline from 2010 numbers even as other banks continued to see stability and improvement.
If that’s what’s happening now, just imagine if new regulations take a bite out of the balance sheet in future quarters.
Most disturbing is that, like AIG, Citi has to sell some of its best growth opportunities to keep its operations in good standing with the government. Reports emerged just before the stress test that Citigroup plans to sell its almost 10% stake in Housing Development Finance Corp., India’s largest mortgage lender. True, the opportunity hasn’t lived up to the hype since Citi’s 2005 buy-in — but getting out of emerging markets when North American operations remain lackluster isn’t much of a growth plan.
Take your profits in Citi if you own shares. If not, sit this stock out.
Jeff Reeves is the editor of InvestorPlace.com. Write him at firstname.lastname@example.org, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. As of this writing, he did not own a position in any of the aforementioned stocks.