By Jake Mann
A value trap is kind of like the low-priced food that a supermarket sets near its entrance - it looks attractive at first, until one considers the reasons as to why the food may be so cheap. In the investing world, some of the most successful money managers have made their livings plucking undervalued stocks out of the bargain bin, but it can be dangerous to buy only based on the metrics. In some cases, a stock's earnings or cash flow multiple may be low because there are fundamental changes affecting that particular company, or uncertainties about what the future macroeconomic environment may hold. In the financial sector, most of the biggest banking stocks are trading at prices significantly below their pre-recession highs, but a sluggish American recovery, Eurozone worries, and the unfolding JP Morgan Chase (JPM) crisis may form an impenetrable investment ceiling, so to speak.
According to the metrics, one of the most attractive banking stocks looks to be Citigroup (C). Using the Price-to-Earnings ratio, which estimates the value that investors are placing on every dollar of earnings, is a good place to start. In theory, all stocks in an industry should have similar P/E ratios over the long haul. Presently, Citigroup has a P/E of 7.6X, which is below the banking industry's average of 9.6X, and C's own 10-year historical average of 16.2X. Perhaps more importantly, though, we need to account for future earnings, as many banks' historical earnings data may be skewed by the most recent financial crisis. For this, the Forward P/E is useful, which is based on 12-month analyst estimates of future earnings. In this case, Citigroup's Forward P/E of 5.7X is below primary competitors like Bank of America (BAC) at 6.8X, Wells Fargo (WFC) at 8.6X, U.S. Bancorp (USB) at 10.3X, and JP Morgan Chase at 6.4X. Additionally, it is also important to normalize these ratios for earnings growth by using the Price-Earnings-Growth ratio, or PEG for short. Typically a PEG below 1 indicates that a stock is undervalued. Citigroup's is currently 0.7, which is also less than the PEGs of USB and JPM.
Moreover, it is helpful to determine how investors are valuing a company's cash flows using the Price-Cash Flow ratio. Citigroup's P/CF ratio is 1.7X, which is actually slightly above the industry average of 1.6X, and middle-of-the-road compared to competitors: BAC (1.5X), WFC (13.9X), USB (9.0X), and JPM (1.3X). In real terms, Citigroup's operating cash flow did grow by a significant amount last year, increasing from $35.7 billion in 2010 to $44.7 billion in 2011. Looking to the top-line, the company's revenue shrunk by 9.5 percent over this same time, while year-end results for competitors were mixed: BAC (-15.2%), WFC (-5.0%), USB (5.3%), and JPM (-5.3%). Even though Citigroup did not experience the sharpest revenue contraction, a figure near 10 percent should not be taken lightly. The majority of this revenue decline occurred as a result of the company's continuing liquidation of the riskiest assets in its Citi Holdings division.
Consisting primarily of a toxic home mortgage pool and a flawed credit card business, Citigroup execs believe that these downsizings will improve the risk profile of the bank in the long run, though it remains to be seen how it will use the sales' proceeds. It was hoped that C could use this cash to initiate a stock buyback program to boost its stock price, but this move was recently prohibited by regulators. Furthermore, the company was one of the only banks that received an 'incomplete' on the Federal Reserve's stress test in March. Specifically, the Fed requested that Citigroup resubmit its capital plan detailing if the bank would be able to withstand another 2008-type downturn. Presently, shares of Citigroup are trading around $27, close to the stock's 52-week low of $21.40. Over the past year, shares of C have dropped 34 percent, compared to a -10.20% return for the financial services sector, and a -22.23% return for the global banking industry.
In recent weeks, greater-than-usual uncertainty has surrounded U.S.-based banks, as JP Morgan's $2 billion loss using credit derivatives has many wondering if heavier regulation is on the horizon. At this same time next year, it is expected that the famed Volcker rule will be in play, a rule that bankers herald as a profit-cutting, liquidity-reducing mistake. In its current form, the rule is expected to still allow hedging techniques to be used, though Jamie Dimon and Co. have given regulators a greater case to squash this loophole. While it remains to be seen how the finalized Volcker rule will materialize, Citigroup and its banking peers are no doubt praying for the least severe version. Adding to this dreary economic backdrop is a looming debt downgrade by the three major ratings companies. Preliminarily, it has been reported that investors should expect a one to two-notch downgrade on Citigroup bonds by the end of the calendar year, a demotion that could be placed on other major banks as well. Expectedly, Citigroup execs anticipate that this would cost the company over $2.1 billion, which is likely a conservative estimate.
Additionally, first quarter 13F filings show that fund manager Bruce Berkowitz, who has been one of the most avid supporters of the financial sector since the recession, trimmed his holdings in C by more than half. Most likely, he reached a similar conclusion - there is an extreme amount of ambiguity surrounding Citigroup at the moment. The wisest move may be for investors to take a 'wait and see' approach through the summer to see how this situation shakes out. Value-lovers must be wary of the bank's attractive valuation ratios; just because something is cheap doesn't mean it is a good buy. As mentioned above, there may be fundamental reasons as to why it is cheap. This adage has proven to be correct in the past, and perfectly applies to the current situation of Citigroup.
Disclosure: I am long C.