Financials For A Power Portfolio

by: Emmet Kodesh

My premise is that we are in for several years of considerable socio-economic and geopolitical turmoil and for decades of diminished life circumstances for most people. Demographic decline and changes in governance and employment options will define a period of increased regulatory oversight, controls and extractive management.

Based on this macro outlook, I have been presenting a series of articles on the best companies in sectors which should out-perform going forward. These mainly are large or mega caps in the global power matrix. I have discussed consumer discretionary, media-entertainment, industrials, precious metals and other commodities. This article seeks to identify the best major financial companies to include in your portfolio of kings. It also might be called a rough weather portfolio.

In the short term, there are many reasons to expect a significant market correction. New buying should be temperate until there is more clarity on currency-economic issues, QE policy and USA-NATO involvement in the Middle East. Companies profiled here look, as of now, like long-term holdings. The focus is on Western banks widely traded on American markets.

When one reviews revenue / debt or cash flow / debt ratios in this sector, an initial feeling of alarm may arise. By these measures, this sector makes shaky precious metal miners look sound. What one finds in banking-finance is the power and fact of leverage in securing profitability. The coverage ratios are strong. The matter of derivatives is a concern, which will not be covered here. It is, however, part of the macro view set forth above.

Financials have had a strong year after a miserable post-crash slog. The Bank sector on the Nasdaq is up 21.2% this year with the NYSE Financials up 11.6% against +14.5% S&P and +13.05 for the DOW 65 composite. Perhaps the 2013 strength of the sector explains the hefty bonuses it is paying out. Vanguard's Financial ETF (NYSEARCA:VFH) has been strong since 3Q 2011: since its Nov. 14, 2012 low at $31.59 it has risen 35.2%. Still, it is only this quarter that it has returned to its level of a decade ago. VFH's top four holdings are Wells Fargo (NYSE:WFC), JP Morgan (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC). VFH has a low expense ratio of .19 and currently yields 2.04%.

Blackrock (NYSE:BLK) stands out among the American companies in the sector. It has a very strong coverage ratio and is one of the few American majors with a positive revenues / debt, currently 10:7. Its cash flow is more than half its total debt and total debt / equity, per the SA portfolio tool is only .28. BLK has impressive 13% earnings growth, yields 2.6% on a 41% payout from massive $15.95 EPS (Q4 projected by analysts on yahoo finance). EPS for 2014 are projected at $17.55. Its dividend is in line with its 5-year average of 2.4%. Its market cap is $44.3 billion and it is the fifteenth largest holding in VFH.

WFC looks like the next soundest American bank. Its debt / equity at 1.22 is good for major American banks and is sustained by a coverage ratio of 7.6 and $20.3 billion cash flow. Its revenue growth is negative 1.6% and the $3.69 EPS is less than most American but more than foreign major financials. It yields 2.8% on a sustainable 27% payout.

State Street Corp (NYSE:STT) has a market cap of $29.8 billion and sound footing relative to the sector. Its revenues are 5:6 total debts, cash flow is 1:4 debts and its total debt / equity is .62. It has 1.6% revenue growth and $4.59 EPS which supports a yield of 1.6% on a modest payout of 22%. It is the 20th largest holding in VFH.

Rounding out what look like the best six major American financials are JP Morgan , American Express (NYSE:AXP) and Goldman Sachs (NYSE:GS). JPM's massive $109 billion revenues are 1:2.9 total debts and its total debts / equity is 1.63. It has a strong coverage ratio of 4.3 though the $23.6 billion cash flow is but 7% of debt. Still it supports $5.98 EPS and a hefty 2.9% yield on a modest 20% payout ratio. The current yield is slightly above the 5-year average of 2.3%.

AXP has 2:3.1 revenues / debt and its coverage ratio of 4.2 is nearly identical to JPM. Its revenue growth is better at 2.6% and the $4.19 EPS support a 1.3% yield on 20% payout.

GS revenues / debt are a daunting 1:4.9 and its total debt / equity a high 2.8. However, it is growing revenues at 9%, has a good 2.8 coverage ratio and massive $16.40 EPS. It yields 1.3%, precisely its 5-year average on a low 12% payout. Analyst 12-month estimates are $165/share, 8.5% above its current price. JPM, AXP and GS are the second, sixth and seventh largest holdings respectively in VFH. I would use these six best American financials together with the foreign banks mentioned below in tandem with an allocation to VFH that suits your desire for diversity in the sector. VFH had 535 holdings as of July 31. The well-regarded BB & T (NYSE:BBT), capitalization $23.9 billion and $2.43 EPS, is twenty-fifth in the holdings of VFH.

The best foreign banks by primary metrics are British and Canadian. Four stand out when considering the main measures together: Bank of Nova Scotia (NYSE:BNS), HSBC Holdings (HBC), Royal Bank of Scotland (NYSE:RBS) and Barclays (NYSE:BCS). BNS looks like the soundest of this quartet. Its revenues are 91% of debt and total debt / equity is only .81. Its revenue growth is an inviting 8.2% and $5.33 EPS are strong. Along with $6.56 billion cash flow that is 24% of revenues it yields 4.1% on a payout of 43% that like the dividend itself is high for the sector but in line with its 4.3% 5-year average.

Giant HBC whose $191.3 billion market cap makes it a peer of JPM and WFC has revenues 4:1 debt and a total debt / equity a tiny .17. Its coverage ratio is not as great as the best American financials like BLK, STT, WFC and JPM and its revenue growth is negative. However its $17.6 billion cash flow at 3:5 debts is strong and its $4.17 EPS are in line with peers. It currently yields 3.7%, a bit below its 5-year average at 4.3%.

RBS revenues are 1:1 total debts, a rarity in the sector. Its total debts / equity at .38 also is small, third best in this group after HBC and BLK. RBS however currently has negative 5.6% revenue and a relatively weak .6 coverage ratio. BCS is perhaps a better choice: its revenues / debts at 5:3 stand out among major financials and it has 4.4% revenue growth and a small .44 total debt / equity ratio. It has lowered its 5-year average yield from 4.8% to 1.4% to address negative EPS.

Two major European firms, Deutsche Bank (NYSE:DB) and Credit Suisse do not stand with the American, British or Canadian peers. Both have about 4.5:1 debt / revenues, total debt / equity near 3.7, lower coverage ratios and far lower EPS, perhaps reflecting greater exposure to countries in the Euro zone with extended Sovereign debt crises. BAC is more in line with these metrics than with its American peers.

While some investors may be uneasy with financials given events of the past decade, these companies are intrinsic to the power matrix and cultural change. Choose a few of the American financials that look best to you, a couple of the British - Canadian ones and, if it suits your strategy, balance individual holdings with a low cost ETF like VFH.

Perhaps China's official PMI, rising to 51 in August from 50.3 in July and now at its highest in sixteen months will help all economies and sectors globally, offsetting India's continuing difficulties and a rough August for most major indices. Certainly Chinese growth should help commodities as I suggested here. In the meantime and after the present turbulence resolves itself, attach yourself to the strongest majors in financials, media, commodities and industrials.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.