5 Financial Stocks Hedge Funds Love

BALTIMORE (Stockpickr) -- What's the smart money buying this summer? Financial stocks, for one thing. So far, just shy of a hundred hedge funds have reported their second-quarter holdings to the SEC, and these fund managers have been piling on the financial sector, adding onto a small number of names.

"13F season" is officially starting to get red hot, and the early holdings being reported by hedge funds are telling -- especially because they're subject to less lag right now.

And since we're looking at fund holdings in the aggregate, they're less impacted by the fact that some funds might not have filed yet. Consider it a sampling of the trillions of dollars managed by hedge funds: a sneak peak.

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It's clear already, though, that hedgies are buying financial stocks. And not just any financial stocks. With anxiety still prevalent in the market this quarter, hedge funds focused on buying staid, large names in the financial sector, looking to snap up bargains in a group that's underperformed the S&P 500 in 2012 without turning to the risks of big banks.

To peek at hedge fund holdings, we're turning to a new set of 13F filings that are hitting the SEC's mailbox right now.

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Institutional investors with more than $100 million in assets are required to file a 13F - a form that breaks down their stock positions for public consumption. From hedge funds to mutual funds to insurance companies, any professional investors who manage more than that $100 million watermark are required to file a 13F. And by comparing one quarter's filing to another, we can see how any single fund manager is moving their portfolio around.

Without further ado, here's a look at 5 financial stocks hedge funds love.

American International Group

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First on the list is one of the unlikeliest of names: American International Group ( AIG). If hedge funds are trying to skirt the risks of the big banks, why on earth would they turn to AIG, the poster boy for the financial screw-ups of 2008? The best example of a black swan catastrophe imaginable?

Because it's a different company, for starters.

AIG emerged from the financial crisis as the recipient of a series of gut-wrenching bailouts from the U.S. government, around $182 billion in total. But even after the fire sale that AIG had to undergo at its darkest hour, the firm is still one of the biggest insurers in the world.

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Even more surprising may be the fact that the government is actually making money on the AIG deal. Uncle Sam's breakeven price for shares is $28.72, a level that's well under foot right now. And so the government has been exiting its ownership stake in AIG since 2011, shifting the firm from a ward of the state to a real, live standalone company once again.

However you feel about the AIG bailout, it's hard to compare the AIG of today with the AIG of before. There's a new (and experienced) management team in place. The less attractive (and riskiest) businesses have been jettisoned. But the firm still has the scale to compete with any insurer on the market today, and once Wall Street gets over the bitter taste in its mouth from old AIG, this stock should be able to catch more of a bid.

Hedge fund managers agree: They snapped up 3.07 million shares of AIG in the second quarter, more than doubling their stake to $174.7 million.

AIG shows up on a list of 10 Stocks of Top-Performing Mutual Funds in 2012.

Charles Schwab

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It's been a solid year for shareholders of Charles Schwab ( SCHW), a fact that I find pretty telling given record-low rates and the gun-shy nature of stock investors over the last couple of years. Since the first trading day in January, Schwab has rallied more than 17%, besting the broad market by a wide margin.

And hedge fund managers have been participating in the Schwab trade, piling on 7.28 million shares in the second quarter, a move that triples their previous holdings in the stock.

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Charles Schwab is one of the biggest discount brokers in the world, operating a network of around 300 branches spanning the country (and a tiny presence overseas). In the last decade, Schwab has made big strides towards expanding its financial service offerings, adding a banking arm, a mutual fund business, and a bigger institutional presence to its menu.

Low rates and spooky equity markets are tough for brokers: they mean that firms earn much lower interest from cash on account, and that trading commissions are much lower than in full-on bull markets. Even so, Schwab has managed to compensate by boosting the proportion of its sales that come from nascent fee-based operations...

With substantial net profit margins flowing off of its income statement, a decent balance sheet, and even a modest dividend payout, Schwab looks in solid shape to keep outperforming the rest of the sector in 2012.

Capital One Financial

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Capital One Financial ( COF) isn't just about credit cards anymore. The $33 billion firm took the great recession as an opportunity to branch out, buying up traditional retail banks at bargain prices. While COF had already owned banks for nearly a decade, its scale has truly ballooned in recent years, making the firm the sixth-biggest bank in the country by deposits right now.

But both before and after the change, Capital One's bread and butter has always been consumer lending. The firm is one of the biggest Visa (V) and MasterCard (MA) issuers in the country, and a major auto lender. The retail banking business isn't inconsequential -- quite the contrary. It provides COF with an ample flow of dirt-cheap capital that it can lend out at rates that are traditionally on the high end of the spectrum. One result of that is a net profit margin of nearly 20% last year.

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As a well-capitalized "bank," Capital One doesn't have to worry about the same regulatory pressures faced by peers that are handing onto their own capital requirements by the skin of their teeth. With rates just about as low as they can go right now, Capital One stands to benefit immensely when rates reverse and turn higher. Its loans are tied to benchmarks, giving it a wider spread between the interest it charges borrowers and the interest it pays out to savers at Capital One Bank.

Hedge funds have been taking notice of Capital One lately. Funds bought 1.6 million shares of the firm in the second quarter, boosting their holdings of COF by more than 10% to $610 million.

Capital One was included on a list of 10 Stocks to Watch During Earnings Season.

Hatteras Financial

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It's been a fairly perfunctory year for Hatteras Financial ( HTS), and that's just the way investors like it. The firm is a mortgage REIT, a unique type of financial firm that owns agency mortgage securities. While that sounds like risky business to anyone who remembers the alphabet soup of mortgage-related securities back in 2008, the truth is that it doesn't get any safer than agency securities: they're backed by the full faith and credit of the U.S. government.

Without credit risks, Hatteras earns its keep by ramping up its leverage, borrowing money cheaply to buy income investments that pay out higher interest payments. Since Hatteras owns a portfolio of agency-backed investments, lenders see it as relatively low-risk, and since homeowners are individually higher risk, the spread on rates is designed to work in HTS' favor -- and by and large it has.

As a REIT, Hatteras is obligated to pay out more than 90% of its income as dividends. That's resulted in a massive 12.7% yield right now. While uncertainty over interest rate policy is one of the biggest reasons why investors are skittish about HTS right now, the firm should have the wherewithal to refinance its debt quickly or rebalance its portfolio to counter any big benchmark moves.

Hedge funds picked up more than 2 million shares of Hatteras in the last quarter, more than tripling their stake in the firm -- and ramping their exposure to $95 million.


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Last up is Allstate ( ALL), a household name that ranks as the country's second-biggest personal lines property-casualty insurer. The firm insures cars and homes and provides life insurance and other financial products through a network of 13,000 Allstate agents as well as a network of banks and independent agents. That network size, and the success of Allstate's brand, bode well for the stock right now.

That's because insurance has become largely a commoditized business in the last few decades -- in other words, all policies are more or less created equal. That creates immense competition for insurers trying to perfectly balance between providing costs low enough to snatch customers and margins of safety that are sufficient to protect from losses and earn profits underwriting policies. Allstate's reputation and customer service give the firm the ability to be a bit more risk-conscious than many of its rivals, but ultimately if ALL can't compete on price it's going to lose business.

Post-2008, ALL trimmed its homeowners portfolio to shed some catastrophic risk from its balance sheet, instead opting to pile on exposure to the much better-quantified auto insurance business. While Allstate isn't the most exciting name on this list, it's nevertheless a solid way to get exposure to the insurance business, with a bit of income on the side: Allstate currently pays out a 2.3% dividend yield.

Hedge funds bought 1.28 million shares of Allstate in the second quarter, nearly doubling their holdings in the firm.

To see these stocks in action, check out the at Hedge Funds' Favorite Financial Stocks Q2 portfolio on Stockpickr.

-- Written by Jonas Elmerraji in Baltimore.


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At the time of publication, author had no positions in stocks mentioned.

Jonas Elmerraji is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.

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