Wednesday, August 24, 2011

Look to the Big Fish in the Financial Pond

These stocks can arise from the ashes of economic turmoil

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
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.

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