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If you believe in the housing recovery, financials might be an interesting sector to add to your 2013 portfolio. The rally in housing has been good news for banks where mortgage volumes have shown a steady increase in the fourth quarter of 2012. U.S. mortgage originations for the first quarter of 2013 ended at $372 billion, up from $290 billion in 2012. Banks such as Bank of America (NYSE:BAC), and Wells Fargo (NYSE:WFC) have benefited from this increase in originations, and showed an improvement in its mortgage banking division. If the economy shows signs of continued improvement in job growth, we might witness an improvement in mortgage default rates too. Hence one way to play the upside in the housing sector is the financials sector. An improvement in earnings could mean banks returning cash to shareholders in the form of dividends.

To create the list below we began with a universe of financials stocks that have outperformed the market over the last quarter, with quarterly performance above 10%.

We then screened for names that appear undervalued relative to the Graham Number. The Graham Number is a measure of maximum fair value created by the "godfather of value investing" Benjamin Graham.

It is based on a stock's EPS and book value per share (BVPS).

Graham Number = SQRT(22.5 x TTM EPS x MRQ BVPS)

The equation assumes that P/E should not be higher than 15 and P/BV should not be higher than 1.5. Stocks trading well below their Graham Number may be undervalued.

Finally, to see if they might have more upside we reviewed the 13Fs in search of bullish sentiment from institutional investors, with significant net institutional purchases over the last quarter representing at least 5% of share float. This indicates that institutional investors such as hedge fund managers and mutual fund managers expect these names to outperform into the future.

Only 3 stocks made our final list.

For an interactive version of this chart, click play to see the change in the 1-year return of the 3 stocks mentioned below.

A Closer Look

We looked at Colony Financial, Inc. (NYSE:CLNY) in more detail. The stock is trading around $21.95 versus its 52-week high of $22.38, up 42% in the past 1-year. The company maintains a strong balance sheet with $126 million in cash, and $144 million in available borrowings under its credit line. As of September 30th, 2012, the company was in compliant with the financial covenants under the credit facility. Details of which have been provided below:

The company is committed to returning cash to shareholders, evidence of which was the announcement of a $0.05 special dividend declared on December 17th, 2012. The stock currently yields 6.4%.

We would also like to point out that the company reports earnings after market close on March 6th, 2013.

Do you believe in this attractive dividend story?

The List

Do you think these names will continue to outperform? Use this list as a starting point for your own analysis.

1. Colony Financial, Inc. : Focuses on acquiring, originating, and managing commercial mortgage loans and other commercial real estate-related debt investments.

  • Market cap at $324.05M, most recent closing price at $21.95.
  • Net institutional purchases in the current quarter at 13.9M shares, which represents about 39.69% of the company's float of 35.02M shares. The top 2 holders of the stock are SAB Capital Management, and The Vanguard Group.
  • Diluted TTM earnings per share at 1.37, and a MRQ book value per share value at 24.24, implies a Graham Number fair value = sqrt(22.5*1.37*24.24) = $27.33. Based on the stock's price at $21.93, this implies a potential upside of 24.65% from current levels.
  • Performance over the last quarter at 13%.

2. Crexus Investment Corp. (NYSE:CXS): Operates as a specialty finance company in the United States.

  • Market cap at $1.02B, most recent closing price at $13.31.
  • Net institutional purchases in the current quarter at 11.9M shares, which represents about 17.77% of the company's float of 66.96M shares. The top 2 holders of the stock are Wells Fargo & Co., and Goldman Sachs & Co.
  • Diluted TTM earnings per share at 1.24, and a MRQ book value per share value at 11.93, implies a Graham Number fair value = sqrt(22.5*1.24*11.93) = $18.24. Based on the stock's price at $13.33, this implies a potential upside of 36.86% from current levels.
  • Performance over the last quarter at 11%.

3. Icahn Enterprises, L.P. (NASDAQ:IEP): Engages in investment management, automotive, gaming, railcar, food packaging, metals, real estate, and home fashion businesses in the United States and internationally.

  • Market cap at $7.5B, most recent closing price at $71.49.
  • Net institutional purchases in the current quarter at 648.7K shares, which represents about 9.15% of the company's float of 7.09M shares. The top 2 holders of the stock are Carl Icahn, and Horizon Kinetics LLC.
  • Diluted TTM earnings per share at 6.23, and a MRQ book value per share value at 47.84, implies a Graham Number fair value = sqrt(22.5*6.23*47.84) = $81.89. Based on the stock's price at $68.33, this implies a potential upside of 19.84% from current levels.
  • Performance over the last quarter at 55%.

*Institutional data sourced from Fidelity, all other data sourced from Finviz.

Source: Hedge Funds Are Buying These 3 Outperforming And Undervalued Financials