Gingerly Wading Back into Financials

The investment landscape constantly shifts. As money chases returns, prices adjust and fortunes are made and lost. For years, a massive bull market reigned, in which investors who bought dips and patiently awaited a market rebound saw their wealth increase. As this pattern played out, a common source of investor interest was the large financial firms. Since the financials provide the credit that allows our economy to function, people who bought the financials on dips did very well. Then a credit crisis hit and the rule book was shredded.

As a value investor, I believe that any asset has value at the right price. Whether we are discussing a pile of broken furniture or stock certificates, buy at the right level and gains will come your way. This strategy serves as a trusty tool in determining when I should allocate capital.

The difficult part of using this strategy is determining when a value stock morphs into a value trap. Anyone who owned shares of Lehman Brothers or Circuit City now knows that stocks can go to zero. While these investors thought they were buying shares of large companies at cheap levels, the share price only became cheaper as bankruptcy beckoned. For most, the fine line between a value stock and a value trap is only visible in hindsight. Buying stocks entails risks, and you should only allocate capital if you are comfortable with the risks being taken.

Each week in my newsletter EPIC Insights I scan for value and recommend areas where patient investors can allocate capital and earn strong returns. For this week's fundamental trade, I recommend small positions in a sector that involves tremendous risk, but may offer even greater rewards - the banking industry.

I could cover thousands of pages discussing why an investment in the large banks is both risky and necessary. We know our economy will eventually recover, housing will eventually bottom, and markets will eventually function normally. When this occurs, banks will be at the center of the turnaround. However, we also know that banks do not fully understand the depths of their credit risk, more problems will eventually occur, and an intrusive federal government will make the environment more difficult. Some banks are nearly 90% from their all-time highs and so low in price that they offer a perpetual option on the recovery of the U.S. financial system. Given the upside potential, I believe a stake in the large banks is warranted.

When dealing with such a risky trade, we must consider how to protect our capital. As Monday showed, banks stocks remain very volatile as fears of mounting losses and creeping nationalization increase uncertainty and lead to lower prices. For my part, I will use the same rules I apply when trading options-keep positions small, and only invest what you are willing to lose. With that mandate in mind.

I recommend a 0.75% position in JPMorgan (JPM), Bank of America (BAC), Wells Fargo (WFC), Citigroup (C), Sun Trust (STI), Goldman Sachs (GS), and Morgan Stanley (MS) as this week's fundamental trade. With total exposure to the banking sector totaling 5.25% of the portfolio, we will do well when the sector recovers yet will not have a further weakening in share prices devastate our portfolio.

Comments

[1worldcurrency:]

88 trillion in derivatives for JPM.
Wake up already.

Jan 21 09:04 AM

[Jim Hawthorne:]

Ah!!!! The good old, 'jeepers, there's got to be a winner in here amongst all these turkeys somewhere' investment philosophy combined with the 'at these prices, even the sickest dog is a bargain' rule!

Look, Sean, why not lighten up here, okay?!?!

Load up the wife and kids and head for the nearest Kickapoo Casino! Sure, you'll lose some money, but at least everyone will have a good time!

Jan 21 10:51 AM

[Stockmajor:]

The doom and gloom crowd are making 90% plus of the comments about articles written here on Seeking Alpha. I'm not one of them.

Perhaps it is good that so many are bears right now. I've heard it said that it is when most give up and throw in the towel ithat things may turn around. We will see.

I'm long the world economy. It will take time to recover. Yet, we will recover. This is a vastly different world than it was in the 1930s. Governments are responding in a very different manner to this economic crisis. The people of the third world nations, especially China, will not be willing to sit around waiting years and years to bring their lives into the new millenium. They will find ways to get there. And this will help bring the recovery quicker than most here think.

The financials are a speculative play betting on recovery. Which banks will survive? I don't know, but I am willing to bet that most, if not all, of those mentioned in Sean's article will survive. Those who can tolerate the risk, AND can be patient and wait, will see big upside down the road.

Disclosure: I am long ACAS, AIB, BCS, ETFC...because I like long odds and can afford to play.

Jan 21 11:20 AM

[PROXIMO:]

I'd eat my own vomit before I'd go long the banks in this market.

Jan 21 12:00 PM

[Sean Hannon:]

Say what you want about my analysis, but the fact is despite buying all these positions at the open Tuesday morning, I am currently profitable on 5 of the 7 trades with an average return across the entire group of 2.5%. During that same time period the Dow has dropped 1.2%. My only job is to make money for my clients, not offer cynical views. Like it or not, I am on the right side of this trade.

Jan 21 03:46 PM

[PROXIMO:]

Congratulations on your 21/2 % gain on your financial stocks. After 11/2 days. Which means nothing.

On Jan 21 03:46 PM Sean Hannon wrote:

> Say what you want about my analysis, but the fact is despite buying
> all these positions at the open Tuesday morning, I am currently profitable
> on 5 of the 7 trades with an average return across the entire group
> of 2.5%. During that same time period the Dow has dropped 1.2%.
> My only job is to make money for my clients, not offer cynical views.
> Like it or not, I am on the right side of this trade.

Jan 21 04:13 PM

[1worldcurrency:]

Are you saying sell now?
I want an answer by 9:30. I am up 400 % on the year. Despite a trillion in bailouts which no one could predict.

This is not doom and gloom. There is no reason a bank stock should pay a dividend. Anyone can become a bank over night, as we have seen. Their only job is to make money by lending carefully. And they suck at it.

Jan 23 04:07 AM

[1worldcurrency:]

What idiotic corporations pay hundreds of millions in bonuses only to lose billions the very next year?

88,000,000,000,000 trillion. Those are the US Treasury numbers on JPM's derivatives. I don't trust them. I'll bet you it's more.

Jan 23 04:12 AM

[1worldcurrency:]

I guess you're holding. Maybe you'll luck out with a short squeeze. Or maybe a few more hundred billion in free taxpayer money.
I think not.

Jan 23 08:10 AM

[Jim Hawthorne:]

Sean!
You are NEVER 'on the right side' of ANY trade until you sell!

(especially in this market!)


On Jan 21 03:46 PM Sean Hannon wrote:

> Say what you want about my analysis, but the fact is despite buying
> all these positions at the open Tuesday morning, I am currently profitable
> on 5 of the 7 trades with an average return across the entire group
> of 2.5%. During that same time period the Dow has dropped 1.2%.
> My only job is to make money for my clients, not offer cynical views.
> Like it or not, I am on the right side of this trade.

Jan 23 10:34 AM