Bruce Berkowitz is ready for a long Labor Day respite.
The founder of Fairholme Capital, who was named as Morningstar's "Fund Manager of the Decade" for his audacious and well-timed investments, made a major gaffe this summer. He loaded up on financial stocks in the first and second quarters, only to see the whole group take a beating in the recent market plunge. The KBW Bank Index, which is comprised of major bank stocks, has plunged from 48 to 37 in just one month. If he had a "do-over," he'd likely find the group to be even more compelling than before, though he'd certainly be more selective. This may be bad news for Berkowitz, but it's good news for investors like you.
Berkowitz's only real error seems to have been a fixation on Bank of America (NYSE: BAC), which has so many problems it's hard to find anything nice to say. Sure, shares are cheap, but BofA's legal problems remain quite serious and management has lost all respect with investors. Berkowitz even held a staged a Q&A with management on August 11 to ostensibly provide clear answers to tough questions. Big mistake. "Management did little to improve investor confidence... and the answers perhaps left far more questions than answers," writes Sterne Agee's Todd Hagerman. (Warren Buffett's just-announced capital infusion does nothing to change the bank's dim outlook. Its problems are not about liquidity but instead about operational decision-making).
Yet the whole rout in banking stocks obscures a far more appealing story that has emerged in recent quarters. Most other major banks besides BofA are steadily getting much healthier and are poised to be very strong by 2012. And this is happening while the economy remains very weak. Berkowitz's bet, albeit premature, is that investors will eventually note the big disconnect between lagging share prices and brightening outlooks. Let's look at two banks that exemplify why this is a great time to boost exposure to this sector.
Citigroup (NYSE: C) On several previous occasions, I've noted that Citigroup has done a very impressive job of boosting its exposure to Latin America and Asia while reducing its reliance on North America and Europe. I should have also been focusing on the remarkable turnarounds in Citigroup's balance sheet and income statement.
In each of the last two quarters, Citigroup has earned at least $1 a share, thanks in large part to sharply reduced losses in its loan portfolio. In fact, profits would have been even more robust if the bank hadn't decided to spend heavily in Latin America and Asia to rapidly build out its presence. Those regions, which are showing double-digit sales gains for Citigroup in recent quarters, have actually been a profit drag while offices are being opened and talent is being hired. "Expectations for positive operating leverate in LatAm and Asia in 2012 remain encouraging," notes Sterne Agee's Hagerman. Turning those regional drags into profit centers is why analysts expect per share profits to rise from around $4 a share this year to around $5 a share in 2012.
And as Citigroup keeps adding profitable quarters, it is boosting the tangible book value of its balance sheet, which recently stood at $48 a share and is headed to $55 a share by the end of next year, according to analysts. Shares trade for just half of that targeted book value. UBS notes shares historically traded at an average of 2.8 times tangible book during the past 10 years, highlighting just how washed-out this stock has become. Simply trading back up to book value represents a double for this stock.
It's also worth noting the stock also trades for just five to six times projected 2012 profits. This may not last too long. "In our view, the market will eventually recognize that Citi is better positioned and faces far less uncertainty... than BofA," write analysts at UBS after recently noting both banks' stocks have fallen by a commensurate amount this year.
Wells Fargo (NYSE: WFC) For some investors, it's hard to embrace Citigroup after the bank famously imploded in 2008 and had to be re-capitalized. For them, Wells Fargo represents a seemingly safer route, albeit with less potential upside. When I last looked at the stock back in June I noted mega-investor Warren Buffet was "underwater" with this investment. Shares were at $27 back then and are now below $25 and haven't been this cheap for quite some time. As my colleague Ryan Fuhrmann recently noted Buffett's investment firm, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), actually increased its position, and it now accounts for a hefty 19% of the total portfolio.
Buffett is not alone in his ardor for this stock. Goldman Sachs figures shares are worth $37 -- roughly 50% higher than the current share price. When Q2 results were released in mid-July, the numbers underscored Goldman's view that earnings power is approximately $4 (a share) and once the market gets comfortable around this, it should lead to outperformance." Goldman thinks the bank's earnings per share (EPS)will rise smartly in 2012 toward that figure, in part due to a hefty stock buyback that is underway.
Risks to consider: These stocks may stay range-bound f the economy weakens further, although it's hard to see how they can fall much more after approaching such low price/book and price/earnings multiples.
Action to Take --> The most remarkable aspect to these bank stocks is they look very inexpensive at a time when operating conditions are lousy. When the economy finally improves in general, with spikes in employment rates and housing starts then these banks will really be poised for strong organic growth. Current share prices are extremely low in the context of that eventual upturn, and you would do well to consider either of these stocks if you don't already own them.