The past twelve months have been positive for financial companies, with finance becoming one of the best-performing industries with a return of 22.1% (DJ US Financials Index) and outperforming Dow Jones Industrial Average return of 14.8%. Key drivers of this strong performance were the improvement of the housing market, low valuation multiples, and market sentiment driven by a bullish market. In fact, Jim Cramer called the banking sector “the most undervalued sector,” and several prominent investors have been investing in some of the leading names in banking. In this article, I analyze the potential for further gains from Citigroup Inc (NYSE:C), Wells Fargo & Co (NYSE:WFC), and Bank of America Corp (NYSE:BAC).
Citigroup still looks attractive
Citigroup Inc (NYSE:C) experienced a 48.6% return in the past year, driven by its good performance across business lines. Efficiency gains and growth in loans and deposits were key factors that offset a challenging environment of credit compression. Increased revenue from the company’s Investment Banking division also contributed significantly to the bottom line. The 29% year-over-year reduction on Citi Holdings’ assets from 11% of Citigroup Inc (NYSE:C) assets at the beginning of 2012 to 8% of the assets in 2013 helped to improve earnings. Finally, strengthening capital ratios, asset quality improvement, and earnings-per-share growth will ease pressures on capital needs. In fact, the Federal Reserve allowed Citigroup to initiate a common stock buyback program of $1.2 billion after successfully passing the 2013 Comprehensive Capital Analysis and Review stress test.
Looking to the future, the share repurchase program will support Citigroup Inc (NYSE:C)’s valuation and might bolster the stock price. Management is expected to keep reducing Citi Holdings’ portfolio in favorable terms (like in the recent sale of the Brazil-based consumer unit, Credicard), and the recent purchase of the Best Buy card portfolio from Capital One will allow Citigroup to continue growing its retail services segment. In addition, Citigroup Inc (NYSE:C) has one of the strongest international franchises. David Tepper mentioned this in a January Bloomberg interview:
You can look at the earnings estimates on Citi, and we think it potentially has 50% upside from here…get Jamie Dimon on the phone, ask him if there’s one franchise he’d like to buy in the world…he’ll say Citi’s foreign business.
Although Citigroup fundamentals have improved and management is on the right track, risks remain present. For example, the extension of the low interest rate environment or a crisis triggered by events in the Eurozone could have a negative impact on Citigroup and others in the financial industry.
In spite of the recent positive performance, Citigroup is still trading at attractive prices and shows further upside potential. Its price-to-book ratio is 0.8, below the industry median of 0.9, and also below its own historic values. Barron’s market consensus on Citigroup indicates a clear overweight, with a median stock price target of $55. Merrill Lynch recently reiterated its “buy” recommendation on Citigroup, arguing that the company’s strong capital ratios will allow it to increase the capital return to shareholders and possibly acquire US earnings to accelerate the utilization of its Deferred Tax Assets (DTA).
Excellent return on equity and a diversified business model
Wells Fargo & Co (NYSE:WFC) yielded a return of 14.3% over the past twelve months, underperforming the S&P 500 which returned 17.9% over the same period. Wells Fargo & Co (NYSE:WFC) counts with a well-diversified business model that provides revenues across different segments, reducing revenue risk and volatility. Trefis estimates that the company’s Mortgage Lending segment accounts for 26.2% of Wells Fargo $200 billion market capitalization, whereas its Securities and Trading segment accounts for 19% and Loans (Commercial Real Estate, Consumer, Commercial, and Foreign Loans) accounts of 18% of the price estimate. Undoubtedly, one of the company’s key activities in the past year was mortgage loan origination, which experienced an incredible growth of 46% from $357 billion in 2011 to $524 billion in 2012 to reach a market share of 29% of all home-loans issued in the U.S. in 2012.
A significant portion of this mortgage activity was refinancing loans, but the refinancing boom cycle is coming to an end and the key risk is whether the housing market recovery will push new mortgages fast enough or if Wells Fargo & Co (NYSE:WFC) will be able to compensate the expected decline in origination activity with its other sources of revenue.
Wells Fargo & Co (NYSE:WFC) is trading at price-to-earnings of 10.5, below the industry median of 13.4, which suggests that the stock might be undervalued compared to its peers. But perhaps the simplest reason to be long on Wells Fargo is its management’s superb reputation and its strong fundamentals in every single metric.
Like Warren Buffett (who owns 8.7% of Wells Fargo) says: “it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Not quite as attractive
Bank of America Corp (NYSE:BAC) appreciated by 58% over the past twelve months, from $7.96 in May 2012 to $12.24 in May 2013.
In spite of the recent improvement in asset quality, strengthening capital ratios, better expense management, and the approval by the Federal Reserve for capital distributions, concerns remain among investors regarding litigation risks related to Countrywide-issued residential mortgage-backed securities. Returns remain constrained by legacy issues, with a large runoff portfolio in home loans (totaling 36% of the company’s total home loans portfolio) and questions that remain open regarding management ability to improve on profitability ratios once these litigation and legacy problems are resolved. These factors call for caution on Bank of America Corp (NYSE:BAC) attractiveness, irrespective of the bullish sentiment within the sector.
Bank of America Corp (NYSE:BAC) trades at a price-to-book ratio of 0.6, but this low multiple is mainly driven by its poor return on equity of just 1.8%, which is well below the industry median of 6.8% and lower than 84% of the 811 companies in its industry. Although some investors remain bullish on Bank of America Corp (NYSE:BAC), I think that there are other companies within the financial industry that offer a more convincing bullish case than Bank of America with the same level of risk.
To sum it up
To summarize, I am bullish on the financial sector and I think that Citigroup Inc (NYSE:C) and Wells Fargo are still trading at attractive prices while Bank of America Corp (NYSE:BAC) looks cheap but exposed to intrinsic risks.
I believe that investors should focus on strong bank franchises that could do well in an environment of rising interest rates (which drive higher net interest margins). I think both Wells Fargo & Co (NYSE:WFC) and Citigroup represent core holdings of a diversified, long-term oriented portfolio. Wells Fargo has a strong domestic franchise while Citigroup has been expanding nicely in emerging economies during the past 20 years.
The article Analyzing 3 Hot Banking Picks originally appeared on Fool.com and is written by Victor Selva.
Victor Selva has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc (NYSE:C) , and Wells Fargo. Victor is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
