Look to the Big Fish in the Financial Pond

These stocks can arise from the ashes of economic turmoil

bank stocks

Is it time to buy yet? The values certainly are out there, but going long is frightening when every day brings another piece of bad news. Nowhere is this dilemma more pronounced than in the financial sector, where stocks have been obliterated thus far in August. As of Friday’s close, the Financial Select Sector SPDR ETF (NYSE:XLF) was off 18% since July 31, which compares with a loss of about 13% for the broader market.

One positive result of this debacle is that the strongest financial stocks have been tossed overboard with their weaker brethren — setting up longer-term opportunities in some of the sector’s healthiest companies. Foremost among these are JP Morgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Goldman Sachs (NYSE:GS).

Look to the Leaders

Why even consider financials at this point? The short answer is that although investors are growing more concerned about a repeat of 2008, today banks are in much stronger shape than they were three years ago. Most companies in the sector feature better balance sheets, lower leverage and less risky business practices than was the case during the crisis years. The lesson of the early 1990s, 1998 and 2008 is that it can pay handsomely to step up and buy the best financial companies when the broader outlook appears most bleak.

What’s the best way to play the downturn? On one hand, a number of financial stocks in the $5 billion to $10 billion market-cap range are within striking distance of their crisis-era lows. Among these are Fifth Third Bancorp (NASDAQ:FITB), KeyCorp (NYSE:KEY), Regions Financial (NYSE:RF) and Comerica (NYSE:CMA). While it might be tempting to bottom-fish among the sector’s worst performers, the challenging nature of the current market environment calls for a focus on large companies with strong balance sheets, top-notch management teams, dominance in their respective businesses and rock-bottom valuations.

Even more important, it pays to look at stocks whose strong franchises will enable them to benefit from economic turmoil, rather than being victimized by it. Based on these criteria, JP Morgan, Wells Fargo and Goldman Sachs appear to be the best options in the sector.

The case for JPM, WFC and GS

First, let’s take a look at valuation. All three stocks are trading at historically low levels that would seem to indicate an impending disaster:

Forward P/E

P/B

Yield
GS

6.7

0.83

1.2%

JPM

6.1

0.79

2.8%

WFC

6.7

0.99

2.0%

However, a look at the fundamentals shows that no such disaster is at hand. Consider JP Morgan — the company’s capital basis is strong, its non-performing assets and provisions for credit losses are falling, and it has consistently delivered earnings above expectations. Notably, its earnings estimates actually are holding up nicely despite the shaky environment — the company is expected to earn $5.63 in 2012, versus expectations of $5.60 90 days ago.

Further, the company’s healthy balance sheet should enable it to come through the current storm stronger than it was before, just as it did following the 2008 crisis. JPM has an operating margin of 39.9%, which compares with 20.4% for Citigroup (NYSE:C) and 1.9% for Bank of America (NYSE:BAC). None of this is indicative of a company that should be trading at 6.1 times earnings and 0.79 times book.

The story is much the same for Wells Fargo, which also exceeded earnings estimates in recent quarters and has seen its earnings estimates rise in the past 90 days. WFC, which has an operating margin of 34.6%, features falling loan losses, improving loan reserves and the ability to benefit from increased mortgage refinancing activity. The company’s second-quarter profit came in at all-time high, and it is actively cutting costs.

It also should be noted that Warren Buffett, who has owned shares in WFC for over 20 years, has been adding to his stake in recent months. In addition, hedge fund giant John Paulson added to his position in Wells Fargo during the second quarter — the same time period in which he slashed his holdings in Citigroup and Bank of America. It seems as though the smart money thinks Wells is going to emerge from this most recent downturn as a winner.

Goldman Sachs is the most risky of the three because it is subject to regulatory interference, political posturing and legal entanglements. The chart paints a grim picture, as the stock has fallen in almost a straight line for six months with no rally lasting more than four or five days. What’s more, unlike WFC and JPM, earnings estimates have been falling sharply in recent months on concerns about slower capital markets activity and weaker trading results. All of this makes identifying a bottom in Goldman next to impossible.

But — and this an important but — the current environment has provided investors with a chance to buy this premiere franchise at an absurdly low valuation. Those willing to buy on further weakness should see substantial returns for their investment in the years ahead, as it is reasonable to expect both a continued improvement in earnings and a return of Goldman’s valuation to a normalized level.

An Investment, Not a Trade

None of these stocks represent easy money at this point. Further, timing is of the essence. Being right on the fundamentals doesn’t mean much right now because an ill-timed purchase can saddle you with a 10% drawdown within a matter of a day or two. Still, unlike many stocks in the financial sector, the primary risk with these three stalwarts is broader market weakness rather than stock-specific developments — an important point of distinction in the current environment.

Daniel Putnam does not own any shares of the aforementioned stocks.


Article printed from InvestorPlace Media, https://investorplace.com/2011/08/financial-stocks-banks-xlf-jpm-wfc-gs/.

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