Watching Capitol Federal Like a Jayhawk

Updated from Friday, June 20.

Sunday, The Financial Times reported that Goldman Sachs ( GS) 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.

TheStreet.com 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%.

TheStreet.com: 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.

TheStreet.com: What is your current take on the financial sector?

Shenoy: Still cloudy.

TheStreet.com: That said, one of the APM fund's current holdings is Capitol Federal Financial ( CFFN).

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.

TheStreet.com: 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 Financial Select Sector SPDR exchange-traded fund ( XLF) is down over 26%.

TheStreet.com: 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.

TheStreet.com: 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.

TheStreet.com: Who runs Capitol Federal?

The Dicus family started the company and continues to run it. The father -- John C. Dicus -- started it and the son -- John B. -- is the current CEO.

TheStreet.com: What role does the yield curve play in Capitol Federal's business?

Shenoy: CapFed's business is very dependent on the yield curve. Net interest income is higher when the yield curve is steeper. They make loans at the longer term rates and pay deposits based on shorter term rates. Now as the yield curve steepens, business should get better. Housing hasn't been as over-built in Northeast Kansas, but it's still slow now. Eventually, housing demand will pick up again.

TheStreet.com: Capitol Federal is headquartered in Topeka, Kansas -- not too far from the University of Kansas. What other local or regional companies does the APM fund currently hold?

Shenoy: Current local holdings include Kansas City Southern ( KSU), Garmin ( GRMN), Inergy Holdings ( NRGP), NIC ( EGOV) and two of Tortoise Capital's closed-end mutual funds that invest in midstream energy MLP's master limited partnerships.

TheStreet.com: Do you advise individual investors to spend time researching local or regional companies?

Shenoy: We think it's a good opportunity. There will usually be someone in the community who knows the good and the bad about the company. We were able to sell NovaStar Financial over-the-counter ticker: NOVS early, based on some local knowledge, but we didn't avoid taking a big bath in Brooke Corp. ( BXXX) Year-to-date, shares are down over 90%.

TheStreet.com: What are the APM fund's current rates of return?

Shenoy: Year-to-date, 0.56%. Since June 30, 2007, 5.6%.

TheStreet.com: What are the fund's current five largest holdings, and why?

Shenoy:
  • Interceramic (Mexico Stock Exchange: CERAMICB)
  • Golden Meditech (Honk Stock Exchange: 8180)
  • Kansas City Southern
  • China Green (Honk Stock Exchange: 0904)
  • Quicksilver Resources (KWK)
  • Interceramic is one of the largest North American tile companies. They have sales in Mexico and in the U.S. The split is about 50/50. Even in a terrible housing environment they have had record U.S. sales in Q1 first quarter of 2008, as European tiles have become much more expensive because of the weak dollar.

    Golden Meditech is a high-tech medical device company in China. They have three main segments - Autologous Blood Recovery (ABRS), Cord Blood Bank, and several smaller segments. 72% of the profits come from the ABRS segment. ABRS is used instead of blood transfusions in China and other places where blood banks aren't common.

    With Kansas City Southern, volumes have been up this year. We initially invested in November 2006 because of the monopoly rail link from the new Mexican port on the Pacific Ocean in Lazaro Cardenas. They are in a great position to capitalize on Asian and NAFTA shipping. They have cut costs by investing in new locomotives. Great position for "intermodal" business.

    China Green produces food in China for both the domestic and export market. The company originally exported primarily to Japan, a notoriously "picky food country," so we know they can produce extremely high quality produce. They have consistently increased their cultivation base. The increase buying power of the growing Chinese middle class is a key driver. They have good logistics and management. They aren't cheap anymore, but still a solid performer. May be time to take some money off the table here.

    Quicksilver Resources is primarily a natural gas exploration and production company. Their primary production point is the Barnett shale in Fort Worth. They have some oil production and are exploring new areas. We generally like natural gas better than oil. We aren't sure where oil prices will be next year, but a lot of companies have switched to natural gas because of its cleaner burn. Demand should stay high.

    TheStreet.com TV: Cramer: Why Nat Gas Is for Keeps

    For more on Shenoy and KU's student-run APM fund, check out "Open Book: How to Beat the Street."

    This article was written by a staff member of TheStreet.com.

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