At Wells Fargo and Citigroup, a Bank-Stock Flight to Quality

But the richly priced shares have some observers looking elsewhere for bargains.
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Bank stock investors are deploying a simple strategy to survive the periodic selloffs that have hit the financial sector this year: Buy Wells Fargo (WFC) - Get Report or Citigroup (C) - Get Report and cling to them for dear life.

Both stocks have outperformed their peers and boast valuations well above the average for this sagging sector.

Now, two investors and one analyst think this strategy has gone too far. While they don't see evidence that Wells or Citi are badly run or about to announce operating difficulties, neither do they think these institutions are as superior as their highflying stocks or rich multiples might suggest. In fact, they contend that banks of equal quality are trading at much lesser multiples. As a result, the two investors are buying the unfairly beaten-up banks and staying away from, or selling short, Citi and Wells.

The Summer Wind

Wells and Citi shares have done remarkably well since June, during which interest rate fears have deepened and some other large institutions have noted operating difficulties. These were illustrated by a warning

last week from

U.S. Bancorp

(USB) - Get Report

.

Since June 30, the

KBW Bank Index

has sunk 14%, but Citi's shares have jumped 13% and Wells' have risen 1.8%.

Highfliers
Citi, Wells vs. KBW Bank Index
(stock prices rebased: Dec. 31, 1998)

Source: Baseline

The share prices of Citi and Wells are around 17 times their 2000 earnings-per-share consensus estimates from

First Call/Thomson Financial

. These multiples are much higher than the KBW Index average of just under 13 times 2000 earnings.

"Citi and Wells have gotten ahead of themselves, and they aren't that much safer than other banks," says David Trone, banks analyst at

Credit Suisse First Boston

. (First Boston, rating Citi a sell and Wells a hold, has done no recent investment banking work for either bank.) It's possible, Trone says, that they could "hit a revenue wall" like U.S. Bancorp, which last week guided earnings expectations lower partly because of sluggishness in consumer lending, an activity that also makes up a large part of Citi and Wells' business mix. Neither Citi nor Wells returned calls seeking comment.

Piggy Banks

Bemused by the two banks' high valuations, one experienced bank stock hedge fund manager, who requested anonymity, is selling them short. "Ultimately, the fundamentals and stock prices have to reconcile," he says. "This can take a long time with Internet stocks, but banks can't fake it for long."

Jeff Miller, manager on the Villanova, Pa.,

Acadia Fund

, another bank-focused hedge fund, does a simple exercise to support his view that Citi is overvalued. (Miller's fund has no position in Citi.)

He says Citi's multiple of 19 times 1999 forecast earnings is well above the multiples that Citi's main businesses would probably trade at on their own. For instance,

Salomon Smith Barney

and Citi's insurance businesses would likely trade around eight to 10 times 1999 earnings, while the commercial bank would trade around, or just above, the current sector average of 14 times.

But this break-up approach doesn't impress Robert Shelton, manager on the

(GFSAX)

Aim Financial Services fund, which is long Citi. He thinks the bank's diversification is one of its main strengths, since temporary weakness in one business line should be offset by buoyancy in others. "All these businesses are worth much more together," he says.

Adds Joe Morford, banks analyst for

Dain Rauscher Wessels

: "It's getting more difficult for banks, but we believe that Wells Fargo is one of the banks that is better positioned to deal with these challenges." (Morford rates Wells a strong buy and Dain Rauscher hasn't done any recent underwriting for the bank.)

Compare and Contrast

It's undeniable that Citi and Wells have produced solid profits this year, but they're not doing better than significantly cheaper banks. For example, Citi's third-quarter earnings were 250% higher than in the year-ago period, with the huge leap attributable to third-quarter 1998 earnings being deeply depressed by the Russia ruble crisis and the near collapse of

Long Term Capital Management

. But

J.P. Morgan

(JPM) - Get Report

, with a 1999 P/E ratio of only 14, posted profits that were ahead 282% over the same period.

P/E ratios, however, can't be viewed in isolation. Investors also look at earnings growth to see if a P/E ratio is justified. For example, if a bank has a rich-looking P/E of around 20, it doesn't really matter if its profits are going to be up 20%. Such a bank's so-called P/E-to-growth multiple would be 1 (20 divided by 20).

But Citi's 2000 P/E is 1.31 times its projected 2000 earnings growth, and Wells' is 1.11 times. Compare this with, say,

Fleet Boston

(FBF)

, whose P/E is only 0.94 of its expected 2000 earnings upside. The KBW Bank Index's P/E-to-growth is 1.16 times.

After several nasty earnings surprises from banks, investors are also paying up for stable, trustworthy profits at Citi and Wells. But other banks' profits are just as solid, according to the table above, which shows by how much analysts have adjusted their estimates for 1999 earnings since the beginning of this year.

Their estimate for Wells is now 0.9% higher, very close to Fleet Boston's 0.7% increase; and

Chase Manhattan

(CMB)

, J.P. Morgan and

Firstar

(FSR)

also look solid on this measure.

"There's so many cheaper banks," says Acadia's Miller.