Buy JPMorgan Chase, Citigroup in 2013 but Avoid Regionals: Sterne Agee

NEW YORK ( TheStreet) - Out of favor large-caps and discounted brokers will be outperformers in 2013, according to Sterne Agee analyst Todd Hagerman.

In a report Thursday, the analyst highlighted "earnings diversity, expense leverage, and ongoing credit leverage" as important earnings drivers for the sector in 2013, though he expects ongoing budget discussions and associated uncertainty to keep economic growth at a "pedestrian pace" through the first half of 2013.

Investors should avoid small/mid-cap regional banks that are overly dependent on spread income and have little expense and credit leverage. Instead they should use volatility in the stock market to pick up large-cap stocks trading at deep discounts.

To that end, Hagerman upgraded JPMorgan Chase ( JPM) and Citigroup ( C) to buy from neutral Thursday.

JPMorgan's reputation took a knock in 2012 after it disclosed a multi-billion dollar trading loss from a botched hedge. Legacy mortgage issues have also weighed on the stock. Shares rose more than 25% in 2012, beating the S&P 500, but underperforming Citigroup and Bank of America ( BAC), which soared during the year.

Still, JPMorgan is "one of the few large multinational banks to earn its high cost of capital in a slow-growth environment," Hagerman noted in his report. It also remains highly levered to a better-than-expected global economy and is "best in class" in capital markets.

While shares could see some additional volatility in 2013 due to mortgage-related matters and regulatory risk, the analyst recommends buying the shares on weakness, "particularly given its inexpensive valuation for a bank that earns its high cost of capital."

The stock's price target was raised to $52, which implies an earnings multiple of 9-10 times the 2013 estimate of $5.35.

Meanwhile, the ousting of Vikram Pandit and the appointment of Michael Corbat as new CEO of Citigroup is a "game changer" for the bank, according to Hagerman. "Immediately tasked with the rehabilitation of both the company's weak financial performance and longstanding management credibility gap, Corbat has come out of the gate early with the recently announced repositioning actions and associated cost reductions. As we head into 2013, we believe this initial step is only the beginning of this newfound restructuring story," the analyst wrote.

In December, Citigroup announced that it would lay off 4% of its workforce as it continues to focus on expenses in a lackluster revenue environment.

Potential catalysts for Citi in the near term include "additional organizational/management changes as well as our expectations for a more favorable CCAR review and more important, validation from the Fed of the progress made over the last few years and months, including the expected announcement of increasing capital redeployment for 2013," he wrote.

At the current price of $41.25, the stock trades at 8-9 times 2013 earnings, making it the "cheapest broker" ending 2012. Hagerman has a 12-month price target of $50 for Citi, implying a 21% upside to the stock.

-- Written by Shanthi Bharatwaj in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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