2 Ways to Play the Rebound in Financials

Includes: BAC, C, JPM, SPY, WFC, XLF
by: Sebastien Buttet

Stock leadership rarely carries from one bull market to the next week. Tech stocks were roaring in the mid-nineties, got clobbered when the tech bubble burst in 2000, and did very little in the last decade. Bank stocks were the leading group of the last bull market between 2002 to 2007 with financial institutions reaping large profits from mortgage securitization and financial engineering. During this time period, the Spyder Financial ETF (NYSEARCA:XLF) outperformed the S&P 500 Index (NYSEARCA:SPY) by more than 40%.

Fig 1: XLF vs SPY

(Click to enlarge)

Today, most financial stocks are in the dog house trading at depressed values reflecting investors' concerns about:

  • regulatory uncertainty from the implementation of the Dodd-Frank bill and new capital requirements from Basel III,
  • punitive legal actions from the government,
  • lack of demand for loans in the housing sector.

WIth most bank stocks trading below book value (usually a timely indicator for when to buy bank stocks) we believe that the sector is ripe for bargain hunting. This is especially true since the Fed gave the green light to most banks to reinstate payments of dividends (payout ratios are likely to go up in the near future). In addition, the recent $8.5 billion settlement between Bank of America and investors who lost money on mortgage-back securities is very bullish for the sector as the North Carolina bank puts its house in order further digesting the Countrywide acquisition.

We review the prospects of the 4 largest bank-holding companies on a relative basis (click here for an analysis of smaller financial institutions with market cap less than $50 billions):

Tab 1: Bank Stats

Stocks Market Cap (in $billions) Price on 06/28/11 close 52-week high 52-week low Price-to-Book Ratio 12-month Forward P/E Div. Yield
BAC $109.6 $10.82 $15.72 $10.40 0.51 10.2 0.37%
WFC 147.6 27.49 34.25 23.02 1.19 10.1 1.75
JPM 160.5 39.54 48.36 35.16 0.91 8.2 2.53
C 120.7 40.15 51.50 36.20 0.69 9.9 0.10

Banks are cheap along two dimensions:

  • Price-to-book ratios less than one (usually a favorable indicator to buy bank stocks)
  • P/E ratios in the single digit or low teens

JP Morgan perhaps can safely be recommended to most investors today because of the quality of its balance sheet, its 2.5% dividend yield, and low P/E ratio. For more patient investors with a 3 to 5 years horizon, Bank of America offers tremendous value with a price-to-book ratio of 0.5. However, BAC still needs to put its legacy issue behind it, notably the Countrywide acquisition.

There are many ways to play the (yet to come) rebound in financials. Buying stocks of the aforementioned banks is the obvious one and investors can pick up the modest dividend while patiently waiting. An alternative to buying stocks that offers a better risk/reward profile in our opinion is to buy long-term (slightly) out-of-the money call options that expire in January 2013. The so-called LEAP calls are cheap because of low volatility and depressed valuations for bank stocks. The benefits of buying the calls are well known: limited downside, unlimited upside with smaller capital requirements. The downside is that investors will not receive dividends.

Tab 2: LEAP Calls valuations

Calls Bid Ask
Jan 13 - $12.50 $1.42 $1.43
Jan 13 - $15.0 0.71 0.75
Jan 13 - $30 3.15 3.25
Jan 13 - $32 2.43 2.49
Jan 13 - $45.0 3.35 3.45
Jan 13 - $50 2.01 2.07
Jan 13 - $45 5.05 5.20
Jan 13 - $50 3.25 3.35

Let us review the mechanics of how options work on a example, the January 13 $12.50 call on BAC. Investors can buy the call today for $143 per contract which gives them the right (but not the obligation) to buy 100 shares of BAC at a price of $12.50 on or before January 2013.

At expiration two events can materialize:

  1. If BAC stock trades below the strike price of $12.50, the call expires worthless and investors have a loss of $143 per contract. Suppose the stock closes at $8 on January 2013. Losses for those who bought 100 shares today would be roughly equal to $300, while the loss for investors who bought the LEAP call is only $143. In other words, the downside for the calls is lower compared to the downside of investors who own the stock.
  2. Now let's evaluate the more profitable scenario (and in my opinion more likely) where BAC stock trades above $12.50 on January 2013. Suppose BAC closes at $21 on January 21, 2013 (the expiration date). The $21 value is the current book-value for BAC so it is not at all unrealistic to assume that BAC would trade at a price-to-book value of one two years from now. Investors who bought 100 shares today would enjoy a 91% rate of return on their investment, having spent $1100 while reaping a $1000 profit. Not too bad! The rate of return on capital would be even higher however for investors who bought a LEAP call. They committed $143 today and at expiration the call would be worth $8.50, yielding close to a 500% return.

In short, we believe that most negative news are priced in bank stocks which are headed higher in the near future. We proposed two very different ways to play them; either by purchasing stocks and collecting dividends; a more aggressive option that requires less capital and offers higher returns is to buy LEAP calls.

Disclosure: I am long BAC.