It’s been a long road since the dark days of 2008 and 2009, but financial stocks are on firm footing going into the second half of 2013.
That means even after a big run in the last year, banks are a buy — especially if the market continues to pull back and give you a bargain entry price.
Here’s why banks are looking good:
Strong Earnings: For 14 straight quarters, bank earnings have improved — with record profits in the first quarter. Yes, top line growth is hard to come by. And yes, some of those improvements have been fueled in part by accounting tricks thanks to a drawdown in reserves. But there is no doubt that banks are very profitable after adjusting to the “new normal” over the last few years.
Valuations: In 2008 it was fair to challenge the book value of a bank since many bad mortgages had not been written down or marked to market. But Citigroup (C) is still trading for a 25% discount on book value, and Bank of America (BAC) is trading for a 35% discount — despite runs of more than 50% for both stocks in the past year. At worst, they are only now fairly valued … but there is real potential for continued upside.
Credit Spread Hopes: Banks are going to enjoy bigger profits once they can enjoy a bigger credit spread thanks to a higher interest rate environment. It may tamp down some mortgage lending, but loans will be more profitable across the board.
Cyclical Potential: When the economy recovers, banks will be there to lend consumers and businesses more cash. If you believe the economy is turning a corner — and I do — it’s a great time to get into banks before the recovery. Dealmaking and IPO activity could also pick up in 2014 and beyond to boost smaller players like Evercore (EVR) and Lazard (LAZ) that specialize in advisory services.
Dividend and Buyback Upside: Megabank JPMorgan Chase (JPM) now boasts a 3.0% dividend yield thanks to Federal Reserve approval on significant dividend increases and stock buyback plans. Other financials like Citi and BofA have been scrambling to get the same approval, and as brighter skies boost the sector you can be sure dividends and buybacks will pick up, too.
Acquisition Potential for Regionals: It’s a hard truth, but the financial crisis only made Too Big To Fail worse as Wachovia was devoured by Wells Fargo (WFC), WaMu got sucked up by JPM and continued consolidation at the regional level has significantly reduced the number of players in the space. Bigger picture that means the big banks are more entrenched than ever — but it also means that the only avenue to growth for mid-sized banks is to keep gobbling up competitors. It’s either that, or be the last fish in the pond to get eaten.
Fewer Failures: So far in 2013, 16 banks have closed and entered receivership according to the FDIC database of bank failures. By this point last year 31 banks had failed. And in 2011, 48 had failed by the end of June. And those were “good” years compared with 2009 and 2010 when the bulk of the financial crisis hit to ruin smaller banks nationwide. In short, fewer failures means that most of the trouble in the sector is behind us.
So how do you play financials if you like what you see here?
Well, it’s hard to go wrong with the big dogs. BofA and Citi are still undervalued and have big upside potential for dividends once they get Fed approval. And JPM and Wells remain the biggest, baddest in the space.
But for most investors, casting a wide net with the Financial Select Sector SPDR ETF (XLF) will serve you well. Or if you want to be a bit more aggressive, banking on the buyout hopes and bigger upside in regionals, the SPDR KBW Regional Banking ETF (KRE) is a good option.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.