Why You Should Own These Financial Stocks - TheStreet

Why You Should Own These Financial Stocks

Both feared and cheap, these bank and brokerage stocks are worth a good look.
Author:
Publish date:

Editor's note: This column was submitted by Stockpickr member Mark Horrell.

A good number of the financial stocks are down around 15% from their highs, and some are down even more. The

price-to-earnings ratios seem to be getting pretty low. And now the market is worried about some leveraged-buyout deals like Chrysler having to remain on their books.

Here's some perspective. Let's say that Chrysler and a few other deals totaling as much as $100 billion have to remain on the books of these banks. The standard loan-loss provision for this type of deal is 1% to 1.5%. So let's use the high side and say $1.5 billion. These deals get underwritten as if the banks are going to own them, so the underwriting isn't going to be awful; let's just say it's OK.

In any given case there are several of the banks/brokers in on a deal. Typically, there are five or so; sometimes more, sometimes less. But let's say five of these guys each have to cover their share of the $1.5 billion loan-loss provision. That's $300 million each.

More perspective: Last year's net income for

Bank of America

(BAC) - Get Report

was $21 billion.

Citigroup's

(C) - Get Report

net was $22 billion, and

JPMorgan's

(JPM) - Get Report

was $14 billion. Considering those profit figures, these three banks alone could easily absorb all of this debt -- $300 million, or even $500 million if only these three participated, is a drop in the bucket. It's almost a rounding error for these companies. So it seems to me that the market's concern is much ado about nothing.

Let's take it one step further. Let's say the implications are that because these recent LBO deals can't get done, there won't be any more such deals and as a result earnings will suffer. I don't see it that way. Here's why.

The high-yield investors are nervous because of what has happened to them in the subprime-mortgage arena. That has them skittish of everything. They are uncomfortable and need some reassurance that something else isn't going to go against them. So, they need better terms on the newer deals. But the

private-equity guys aren't stupid. If they roll over and give in, they have set a new standard for all of the rest of the deals. So they aren't simply going to roll over. They are going to pull deals, negotiate, let a little time pass so that the high-yield Chicken Littles get a little more comfortable.

Make no mistake about the fact that the private-equity groups have raised a bunch of money, and money is chasing this space. The private-equity guys have every economic incentive (a management fee at minimum) to put that money to work, and they will do it. All of the bankers and brokers also have an economic incentive to get these deals done, and there is still a lot of money in the high-yield space that needs to be put to work.

So virtually everyone has an incentive to get these deals done. Thus, we shouldn't necessarily believe the earnings streams of the banks and the brokers are going to fall off in a big way. There may be a pause, but the deals are still coming.

Finally, why is it that only

Countrywide Financial

(CFC)

(a stock I'm net short), reported problems in the prime space in a profit warning last week? No one else seemed to have the same issues. Take note that Countrywide changed how it accounts for charge-offs and it pulled future charge-offs and provisions into the current quarter.

Perhaps Countrywide is using a little sleight of hand in an attempt to make the future quarter comparisons better. Or is it that Countrywide is posturing itself for something else, but at a cheaper price? There are a lot of smart people out there looking at the same stuff, and it's hard to believe that everyone but Countrywide missed this. It seems to me that this broader lending problem is a Countrywide issue.

Where to Invest

The financials are hated and cheap -- that's a great combination. They should be bought down here in my opinion.

Three of the best banks to consider are the big boys: Bank of America, JPMorgan and Citigroup. Bank of America and JPMorgan have forward PEs right at 9 times, and Citigroup's is 9.36 times.

Consider, for example, on average for the last five years, the low forward multiple for Bank of America has been 8.75 times. That's not much downside, and you get a 5.4%

dividend yield while you wait. (Note that if you are in a 35% income bracket, because the dividend is taxed at only 15%, that 5.4% yield is equivalent to a 7.06% taxable bond yield.) It doesn't get much better. Plus, the forward multiples can get out past 11 times.

JPMorgan's yield is only 3.45% because it has a lower payout ratio policy than Bank of America (look for that policy to expand over time). Citigroup's yield is now up to 4.55%. All three stocks represent a good value.

Among the brokers --

Bear Stearns

(BSC)

,

Goldman Sachs

(GS) - Get Report

,

Lehman

(LEH)

,

Merrill Lynch

(MER)

,

Morgan Stanley

(MS) - Get Report

-- the forward PEs are between 8 and 9 times earnings.

Bear Stearns is the least expensive on a price-to-book basis, but all of these are worth considering with Bear Stearns and Goldman Sachs representing the best choices in my opinion.

The risk for all of these is that there could be some earnings revisions in the near term, but these revisions should be a function of a pause or one-time events. And for the most part, this is already assumed in the current prices, so the downside should be limited, especially with the yield protection in the banks.

At time of publication, Horrell was long Bank of America, Citigroup, JPMorgan and Goldman Sachs and was net short Countrywide Financial.

This article was written by a member of the Stockpickr community.

Stock recommendations and comments presented on Stockpickr.com are solely those of the members quoted. They do not represent the opinions of Stockpickr.com on whether to buy, sell or hold shares of a particular stock.

Members should be cautious about any and all stock recommendations and should consider the source of any advice on stock selection. Various factors, including personal or corporate ownership, may influence or factor into a member's stock analysis or opinion.

All members are advised to conduct their own independent research into individual stocks before making a purchase decision. In addition, investors are advised that past stock performance or portfolio performance is no guarantee of future price appreciation or performance.

Furthermore, Stockpickr.com does not guarantee the accuracy or completeness of information on the site, nor does Stockpickr.com assume any liability for any loss that may result from reliance by any person upon any such information or recommendations. Such information recommendations are for general information only.