As a lot of readers will remember, last week I started a new portfolio with the goal of beating the market with a margin high enough to ensure early retirement for investors. The first entrant of the portfolio was Monster Beverage (MNST) and the second entrant was Statoil (STO). Now it's time to add some more momentum to this portfolio and introduce two successful finance companies (I highly suggest reading the Statoil article for the "frequently asked questions" about this portfolio).
What I Look For in Finance Companies
I look for certain qualities in finance companies in order to include them in this portfolio. First, the company has to be profitable. I wouldn't want to get a finance company that struggles to be profitable because finance companies tend to have a higher risk due to the very nature of their business model. Having a positive cash flow allows these companies to stay safe even when the global economy doesn't perform that well. Second, the company has to be growing. When companies are oversold due to worries or panic, they might provide a lot of value. However, most value will come from companies that continue to grow their revenues and earnings. Third, I am looking for companies that have decent valuation and some volatility. High valuation or low volatility will not help us meet the goals of this portfolio, which is to maximize returns for investors.
Addition One: Wells Fargo (WFC)
There are many reasons to like this company. Wells Fargo was able to grow its operating income from $3.26 billion in 2008 to $19.44 billion in 2010 and then to $27.22 billion in 2012. The company's operating income is likely to pass $30 billion in the next year or two. Wells Fargo has been posting double-digit growth in the last 3 years and it has been benefiting greatly from the recovery of the housing market. The bank has posted earnings growth for 5 quarters in a row. Because the company has nearly no exposure to Europe, it possesses less risk than many large institutions that operate in both North America and Europe.
In the last quarter, Wells Fargo posted strong results in many important metrics. For example, return on equity rate was up by 145 bps since the same quarter a year ago. Return on assets metric increased by 18 bps in the same period. Both metrics are at healthy levels with return on equity being at 13.59% and return on assets being at 1.49%.
By the end of this year, the company is expected to earn $3.66 per share followed by $3.88 per share in 2014 and $4.22 per share in 2015. Given the industry average of 14.3, the company should trade for $60 by 2015, which represents a potential upside of 63% to the current stock price of the company (i.e., around $37). In addition, Wells Fargo's dividend yield of 2.4% is above the industry average of 1.8%.
Addition Two: American Express (AXP)
This is another financial company that has relatively low amount of risk compared to others. The company's business model is different than other finance companies because it only deals with clients that have solid credit scores and it takes a higher than average percentage of commission from sellers, which reduces the amount of risk while maximizing the returns. This is what American Express' website says about the company's business model: "Unlike other card issuers, we earn most of our revenues from card member spending and the business we drive to merchants rather than from lending fees and revolving credit balances. Our spend-centric model, lower reliance on lending and broad portfolio of products and services for consumers and B2B customers position us to earn attractive returns."
In the last year, the company's growth started slowing but this is mostly due to the consumer worries regarding the state of the overall economy. In the last quarter, billed business grew by 7%, average basic card member spending increased by 4%, card member loans increased by 4%, pre-tax income increased by 8% and diluted EPS increased by 7% (even though stock buybacks accounted for some of the EPS growth. The company's share count fell by 5% in the last 4 quarters). The growth rate is not as impressive as it was last year, but once the global economy takes off, the double-digit growth rate is very likely to return for American Express.
Analysts estimate American Express to earn $4.78 per share this year, $5.33 per share in the next year and $5.93 in 2015. These estimates represent a growth rate of 50% compared to the $3.95 earned by the company in 2012. The average price to earnings ratio in credit card companies is 31, which means that there is plenty of upside to American Express' current share price of $67.75 as long as it meets the earnings estimates. Keep in mind that American Express has $28 billion in cash and short term investments and another $6 billion in long term investors, which should help the company's valuation.
So we are adding 100 shares of American Express at $67.75 and 300 shares of Wells Fargo at $37.88 to our portfolio. For Wells Fargo shares, we can sell covered calls that expire in July with a strike price of $39.00 which will give us $56 per contract. For American Express, we can sell covered calls that expire in July with a strike price of $70.00, which will yield us $118. Therefore, we are reducing the risk in the short term.