Santander, BofA, Citi: Bet on the Banks

Includes: BAC, C, SAN, XLF
by: Glenn Rogers

I recently read a report from the World Economic Forum ranking global competitiveness based on a number of factors, including the strength of the financial services sector within each country studied. The good news is that both Canada and the U.S. are still in the top 10 although the U.S. slipped from number one to number three. Canada came in with an overall ranking of six, down one position from last year (although it ranked number one for the soundness of the banking system).

That report, combined with the release of the Basel guidelines which mandate that banks raise their capital levels over the next eight years, got me thinking about my three biggest personal holdings: The Santander Group (STD), Citigroup (C), and Bank of America (BAC). I own large amounts of both the common and the preferred shares of these out-of-favour companies. Let me explain my rationale.

For starters, financial stocks in general led us out of the big crash last year but since then they have been lagging the market. Technically, this group has been basically range-bound for some time. That's been true of the market in general, of course. But for stocks to begin a new run, as I believe they will in the next few weeks, the financials need to participate or even lead before we can make much headway. Let's look at each of these financial institutions.

Santander Group (NYSE: STD)

From a value perspective, I like Santander best. I recommended buying this Spanish bank in May when it was trading at $10.44 (figures in U.S. currency). It promptly pulled back to the $9 range over fears of a debt default by Spain but has since rallied strongly and closed on Friday at $12.67, up 21% from my recommended price.

I still like this stock a lot. The company's exposure to Latin America plus the dividend paid by both the common and preferred issues make this a compelling story. Santander is my largest single holding which I add to every time it pulls back. Keep an eye on it and if the price drops below $12.50, add more.

Bank of America (NYSE: BAC)

Bank of America is basically a value play. It's the largest domestic bank with over 6,000 banking centers and more than 18,000 ATMs. It has an enormous mortgage platform, some of which unfortunately includes the marginal assets acquired from Countrywide Financial for $4.1 billion in stock before the meltdown in 2008. The BAC customer base is over 29 million.

The bank also has a tremendous asset in Merrill Lynch. It was acquired during the meltdown and so far that deal is working out well for BAC, certainly better than the Countrywide acquisition. Merrill gives BAC a global footprint and last quarter corporate business in Merrill increased 24% over the previous quarter.

BAC reported net income of $3.1 billion (27c a share) for the second quarter. That was basically flat on a dollar basis compared to the same period last year although earnings per share were down about 18%. The bank has been strengthening its balance sheet with the sale of some minority positions in Santander, Master Card, and a few others. Frankly I wish they hadn't divested some of those assets since it will likely slow growth but at least they are building financial strength in the short term.

The new CEO, Brian Moynihan, recently stated that the plan going forward is to cease the M&A activity and focus instead on integrating existing businesses. That's a significant change from the priorities of his predecessor, Ken Lewis, who presided over $120 billion in acquisitions during his tenure. It's not an exciting strategy but, given the current conditions, is likely the best plan for right now.

The stock closed on Friday at $13.40. That is down 33% from its 52-week high of $19.86. However, I believe it will rally back to that level in the next 12 months.

If cash flow is important to you, have a look at the BAC preferred shares as well. I recommended buying BAC.PR.J last year at $21.50 when the yield was 8.4%. They closed on Friday at $24.90 and the yield is down to 7.3%, but they are still a Buy at under $25.

Action now: Buy BAC common with a target of $20. Buy BAC.PR.J under $25.

Citigroup (NYSE: C)

Citigroup is another fallen star. In fact, it had a very hard landing during the crisis. How hard? Well, back in 2008 the stock traded above $50 and it is now at $3.95. I doubt we will see those heady days again in my lifetime but it is not unreasonable to think the shares might hit $5 over the next year which from these level would be a gain of 26.6%.

I like Citigroup for a few reasons. First, it's cheap so I can buy lots of it which means the leverage is terrific. Second, I believe the downside risk is minimal at these levels since the government has already told us they won't let Citigroup go under. There is an overhang from the government bailout since the feds have been selling off their stock for the past several months. But hopefully that process will be completed early in 2011 which should ease the selling pressure somewhat.

I also like Citigroup's global footprint. The company has operations in 140 countries worldwide in virtually every facet of financial services. They have a large retail business but also a sizable investment business through Smith Barney. Citigroup has significant assets in both Latin America and Asia which will be a growth engine going forward.

The company reported second-quarter earnings of $2.7 billion on revenues of $22.1 billion which, given the nightmare of the past couple of years, shows some decent progress, especially considering they have been shedding assets since the meltdown. Overall, net income was up 21% for the first six months of 2010 compared to the same period in 2009.

This is the most aggressive play of the three. Citigroup still has a lot of problems, which is why the stock is so cheap. But management is gradually gaining control of the situation and it will work through these issues over time.

Some analysts feel that even at $4 the stock is overvalued but I believe it will hit $5 in the next year. There are better-run banks out there like JPMorgan Chase (NYSE: JPM) but they don't have the same leverage and they tend to trade in tandem with the rest of the group.

In addition to the common shares of Citigroup, I also own the preferred issue (NYSE: C.PR.G) which has been trading well. It closed on Friday at $25.70 and yields 7.7%.

Action now: Buy Citigroup common stock with a target of $5.

A couple of other catalysts could move all these stocks. First, financial regulation as a headline issue is receding. The final outcomes are not entirely certain but the overhang is less oppressive. Also, Citigroup and BAC will reinstate dividends as soon as feasible, especially Bank of America. Any dividend announcement should boost investor interest. Finally, I believe the U.S. economy will slowly improve and that can't help but benefit the banks.

Disclosure: Author is long STD, BAC and C