This is a high conviction investment thesis of mine. I am long AIG (AIG), Bank of America (BAC), Goldman Sachs (GS), JP Morgan (JPM) and, just recently, Citigroup (C) and corresponding warrants.
Financial stocks are cyclical stocks in the sense that earnings and cashflows are bound to increase faster than key economic metrics such as inflation and GDP growth in an expansion, and, hence, companies will be operating more profitably with higher ROE's and growth in book value. Once central banks start raising interest rates and officially mark the beginning of the next interest cycle, financial stocks are going to be at the centre of attention. As investors have seen over the last 3 years, stocks do rise in times of adversity and uncertainty. Financial institutions will profit from increased business confidence leading to higher capital market activities, i.e. IPOs, secondary offerings and mergers and acquisitions. More credit will be created, LBOs will again be more aggressively pursued as investors look for higher yields and credit standards will deteriorate again.
As can be seen in the following graph, almost over the entire last cycle, P/B ratios, with the exception of JPM, were on average at around two, which means financial stocks were trading at high premiums to book value. JPM's P/B was one of the more volatile ratios. Even at the beginning of 2003, in a time of uncertainty and fear regarding the Iraq war, P/B ratios have been fairly high. If the investor compares the historical valuations with the ones we see today, it appears that financial stocks are still quite attractively priced. In my opinion, value investors should be more focused on P/B ratios than on P/E ratios as earnings still are temporarily depressed and do not reflect a normalized earnings picture. Investors will likely profit from both earnings and multiple expansion over the next years as an economic recovery takes hold in the US.
(Click to enlarge)
I am especially enticed by hated BAC and neglected C. There is just no explanation as to how the market has treated BAC (down 35%) and C (down 28%) over the last year. BAC trades at P/B at 0.4 and C at 0.54 still pricing in huge pessimism besides having made tremendous progress over the last years. BAC has made good and measurable progress in working through their mortgage issues, while Citigroup also has made good and steady progress in winding down Citicorp, the entity who holds riskier assets. The market, as a whole, seems to be in denial with regard to the opportunities that lie ahead for all major financial institutions which operate in an even more concentrated industry than before. In fairness, concentration helps institutions and their earnings and I do not consider it probable, that in the current political climate the issue of "too big to fail" could or would be addressed.
Just based on the current depressed pricing of financials these stocks are still out of favor and seem to be great value buys for those who have the patience to hold on to them over the entire next cycle. High returns are likely to be made on utter inactivity by just waiting for the sentiment to change and valuations revert to their last cycle average.
