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Watching Capitol Federal Like a Jayhawk

Updated from Friday, June 20.

Sunday, The Financial Times reported that Goldman Sachs (GS - Get Report) is expected to pare up to 10% of workers in a division that handles mergers and acquisition advice and corporate fundraising over the course of the year.

Today, according to a Reuters report, Goldman Sachs downgraded the U.S. financial sector to " underweight."

So are there any bright spots in the financial sector?

KU Stock-Pickers Find a Trend-Bucking Bank

" How KU Stock-Pickers Play Offense" introduced you to Professor Catherine Shenoy and the $1.4 million student-run Applied Portfolio Management investment fund at the University of Kansas ("KU") School of Business. recently caught up with Shenoy to find out how the APM fund has fared during these turbulent market times and to get her take on the state of the financial sector.

The following interview includes one of the few banks that is delivering for shareholders, with a year-to-date gain of almost 25%. The APM class passed on the many of the most well-known companies in the financial sector long before the high-profile meltdowns and shakeups. Why? And what can an incoming APM student or beginning individual investor learn from how your class analyzed the sector and its companies?

Shenoy: Any APM student or investor needs to understand the balance sheet of a financial company. Until it is clear that the credit markets have "cleared" and transactions can take place based on the values on the balance sheets, we probably wouldn't be able to "get close" enough to understand where the values are.

Going forward, the earnings streams may look very different. If the big banks can't boost earnings by using lots of leverage, then we need a new model for large financial institutions. What is your current take on the financial sector?

Shenoy: Still cloudy. That said, one of the APM fund's current holdings is Capitol Federal Financial (CFFN - Get Report).

Shenoy: We've actually held Capitol Federal since late 2002. During the later part of the mortgage boom it was hard [to own the stock] because they didn't do well. Why?

Shenoy: They didn't lower credit standards and lost quite a bit of business. Now they look great. [Year-to-date, shares of Capitol Federal are up almost 25%, while the <b>Financial Select Sector SPDR</b> exchange-traded fund <span class=" TICKERFLAT">(<a href="/quote/XLF.html">XLF</a><a class=" arrow" href="/quote/XLF.html"><span class=" tickerChange" id="story_XLF"></span></a>)</span> is down over 26%.] Per the fundamental investment questions in your book Applied Portfolio Management, how does Capitol Federal make money?

Shenoy: CapFed is primarily a residential lender in the northeastern part of Kansas. They have high credit lending standards and one of the highest efficiency ratios of all lenders. [Capitol Federal has] almost no "bad" loans. "Non-performing" assets to total assets equal 0.12%.

[Capitol Federal is also] well capitalized. What numbers from Capitol Federal's public information demonstrate how well the business is performing?

Shenoy: A misleading number for CapFed is the P/E ratio. Since they are a mutual holding company [MHC], they have public shares and shares held by the MHC. They do not pay dividends on the MHC shares and have stated that they have no plans to do a "second step conversion" -- sell the MHC shares to the public -- until they need to raise cash.

Earnings per share numbers are based on the full share count -- public and those held by the MHC. GAAP EPS in 2007 was $0.44, if you adjust for just the public shares, you'd get $1.46. See table 4.1 from the book. I added 2007.

Capitol Federal Financial's Important Numbers
2005 2006 2007
Interest and Dividend Income ($M) 156 127 106
Net Income ($M) 65 48 33
Dividend per Public Share 2.3 2.09 2.09
Shares outstanding (Millions) 74.3 74 74.2
Public Shares (Millions) 20.5 20.4 22.1
Earnings per share - reported 0.9 0.66 0.44
Earnings per share - adjusted 3.17 2.35 1.46
P/E - reported 36.6 58.7 70.4
P/E - adjusted 10.4 16.5 21
Dividend Yield 5.90% 6.20% 6.70%
Stock Price - Year End 32.94 38.42 31

For the first six months of fiscal year 2008, reported on March 31, 2008. CapFed has unadjusted EPS of $0.29 or $0.94 per public share. At that "run rate," we've got an adjusted P/E of around 21. Higher than the past few years, but it reflects the value that is perceived by investors.

The dividend yield is around 5% and could be much higher. At the end of the year, if earnings are good, the company declares a special dividend to return any extra earnings to shareholders.
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