By ANDREW BARY
Prior to the mid-1980s, when big investment banks like Morgan Stanley (MS)
Now, given the broad, recent selloff in the sector, anyone can buy shares of leading U.S. financial companies near book value or a discount from book. Bank of America (BAC),
It frequently pays to buy profitable financial companies at these levels, because book indicates liquidation value, meaning investors are paying little or nothing for the franchises and earnings power. There can be fluff in book value, because it often includes goodwill from acquisitions and other intangible assets. But some stocks, including Bank of America, Citigroup and Morgan Stanley, trade below tangible book, a measure that excludes the fluff.
A case can be made for all the big financials, based on book value and earnings, with the shares having the potential to rise 25% or more in the next year. Such a gain would leave several, including Goldman, Citi and Bank of America, about where they began 2011 hardly heroic moves. As the table below shows, the six stocks trade for eight to 10 times projected 2011 profits and for an average of just seven times estimated 2012 earnings. The big U.S. financials also are better capitalized than most European peers.
"Patient investors will be rewarded by buying these stocks," says Gerard Cassidy, an analyst with RBC Capital Markets who is bullish on both Citigroup and JPMorgan. "If you have a horizon of two to three years, you should buy Goldman Sachs stock. It has a bright outlook," says Roger Freeman, a brokerage analyst at Barclays Capital.
What's ailing the stocks? Plenty: tighter regulation, more stringent capital rules, a far-from-robust economy, weak loan growth and persistent mortgage woes. The banks lost a battle in Congress last week to ease tough rules on debit-card fees. Another concern: slower institutional trading activity could lead to disappointing second-quarter profits for firms, like Goldman, that depend on trading.
Probably the biggest issue is regulation. Under emerging international standards, big commercial and investment banks may be required to hold more capital than anticipated, given their likely status as so-called SIFIs Systemically Important Financial Institutions. The new capital ratio could be 10% or even higher versus earlier expectations of 8%. Federal Reserve governor Daniel Tarullo rattled the markets June 3 when he said that an argument could be made that SIFI capital ratios should be as high as 14%. While bigger capital bases mean less risk, they also portend lower returns and investors tend to punish low-return companies.
Before the 2008 financial crisis, the big banks and investment banks often earned a return on equity, or ROE, of 20% or higher. Now the fear is that it will be tough to generate 15% returns, and that ROE may be closer to 10% if the capital ratio is set at 10%. Goldman used to target a ROE of 20% on tangible equity over a business cycle, but now won't endorse that goal, due to regulatory uncertainty. It earned a 15% return in the first quarter.
Bulls argue that the stocks already discount ROEs of 10% or less. "No matter what capital ratio they are held to, they should trade for at least book value," says Sanford Bernstein analyst John McDonald.
Decidedly Out of Favor
Shares of the big banks have skidded so much this year, on economic and regulatory concerns, that many of the stocks look like bargains for patient investors. Upside potential could be 25% or more.
JPMorgan emerged from the financial crisis as the country's blue-chip bank, with a lucrative international trading- and investment-banking franchise, sizable and high-return businesses like asset management and processing, as well the industry's best management team, led by CEO Jamie Dimon. Its shares, at about 41, trade below its book value of $43 and for only eight times projected 2011 profit of $4.92 a share. McDonald has an Outperform rating and a $57 price target on the stock. JPMorgan's legal costs alone were $7 billion last year, but should fall as the mortgage mess slowly is resolved.
Goldman, at 134, commands a small premium to its book value of $129, marking a rare instance since it went public in 1999 that it has traded so cheaply. While Goldman is contending with new rules on financial derivatives, restrictions on proprietary trading, uncertain capital rules and government investigations, it remains well-managed and highly profitable. Former mutual-fund star Michael Price said recently that Goldman could be worth $100 more than its current price on a sum-of-the-parts basis, based on the firm's valuable asset-management and merger-advisory franchises.
The Morgan Stanley turnaround has played out slowly, prompting a 17% drop in its stock this year to $23, a discount to its $29 book value and its $26 tangible book. There isn't a lot of confidence that CEO James Gorman can consistently achieve strong trading results while boosting margins in his large retail-brokerage business, Morgan Stanley Smith Barney, to near 20% from the current 10%. Sanford Bernstein analyst Brad Hintz wrote Friday that Morgan Stanley trades below its value if the firm liquidated its trading business while retaining retail brokerage and asset management. In that scenario the stock could be $31. While this is unlikely, it highlights the firm's value. Hintz has a $35 target.
WELLS FARGO HAS HISTORICALLY garnered the highest valuation, relative to book, among large banks, thanks to its high returns and a more understandable business focused on home-mortgage, consumer and business lending that is almost entirely domestic. Housing concerns have pushed its stock down 15% this year, to about 26, due in part to the bank's outsize home-equity portfolio of $114 billion. A bullish McDonald likes the stock, arguing that the mortgage situation is manageable and that the bank should benefit from cost savings as it fully digests its Wachovia acquisition. He carries an admittedly aggressive $40 price target.
Bank of America's stock has a low valuation, trading for 10.65, or just 80% of tangible book, largely due to its mortgage exposure. In describing CEO Brian Moynihan's presentation at a recent investor conference, McDonald wrote that he was "sober about a challenging near-term environment" but upbeat longer-term about expense reductions, its Merrill Lynch retail-brokerage business and international expansion, while stating that he doesn't believe the bank will need to raise capital to meet new rules.
At all of these banks, except perhaps BofA, recent financial results have outpaced the stocks. That's a good sign for investors.