Financial stocks have lagged the broader market by a wide margin thus far in 2011, with the worst of the shortfall occurring in the unsteady tape of the past three months. The causes of the sector’s underperformance include housing market weakness, slower economic growth, tighter regulations, and legal concerns.
At this point, however, these problems are both well-known and heavily discounted into stock prices. With financials so universally unloved, now may be the time for contrarian investors to start looking for opportunities among the sector’s laggards. Two names, in particular, stand out as solid longer-term investments: Morgan Stanley (NYSE: MS) and Bank of America (NYSE: BAC).
Shares of Morgan Stanley are off nearly 25% this year, which compares to a loss of about 7% for the Financial Select Sector SPDR (NYSE: XLF) exchange-traded fund and a gain of approximately 4% for the S&P 500 Index. At its Monday close of $21.58, MS shares stood at just 0.69x book value and about 7.5x 2012 earnings estimates.
Comparatively, the stock traded between 2x to 3x book from 2002 to 2007, while its P/E ranged from 10x to 20x in that time. Keep in mind, this discounted price is for a stock with a top M&A franchise and the largest full-service brokerage in the country, neither of which are likely to be affected by regulatory changes.
This low valuation isn’t without reason, of course. A cloud of uncertainty continues to hang over the stock, resulting in both declining earnings estimates and a falling P/E multiple. Still, this shouldn’t obscure the fact that MS is still estimated to earn $2.85 a share in 2012, and should probably reach the $3-$3.20 a share range in 2013. Even if the P/E only climbs one-third of the way back to its pre-crisis (2002-2007) average of about 15x – not unreasonable given its extremely depressed level – the stock is undervalued by about 30%. As a kicker, Morgan Stanley offers investors a yield of 0.9%.
The banking sector offers numerous potential value opportunities, but Bank of America may be one of the best. While the stock has been cheap for some time, it has only gotten cheaper so far this year, catching both individual and institutional investors in a classic value trap.
It’s also no secret that BAC has been under pressure not just from broader banking sector problems, but also its own company-specific legal issues and the possibility that it may have to raise capital to comply with Basel 3 regulations. The latter concern is likely exaggerated, however, since BAC won’t have to take any near-term actions to comply with rules that don’t go into effect until 2019.
A lack of loan growth has also been a major problem for the stock. But as is the case with MS, the valuation more than takes these obstacles into account – Bank of America stock is trading at just 0.5x book value and 6.2x estimated 2012 earnings, both of which are low, relative to the broader financial sector and the company’s own history. This provides the classic “margin of safety” while investors await the dissipation of bad news – and the inevitable mean reversion in Bank of America’s valuation that will come with it.
Neither MS nor BAC should be viewed as a short-term trade, but as investments that should be allowed to play out over a year or more. After all, both fell to 52-week lows on Monday. The broader market remains shaky, and further bad news on the economy could lead to additional near-term weakness.
The coming earnings season also represents a potential hurdle. Both stocks have had their second-quarter earnings estimates cut in recent weeks — Morgan Stanley because of slow trading volumes and Bank of America due to the settlement payouts related to the financial crisis.
However, this may turn out to be a positive since both have a relatively low bar to overcome at this point.
The bottom line: While both Morgan Stanley and Bank of America continue to face meaningful headwinds, the risk-reward equation has begun to favor the longer-term investor.
