How To Buy a Bank (and Other Beaten-Down Stocks)

by: Philip Davis

People have asked about bank investing so let’s talk about that.

One of the reasons I tend to get very good results is because I listen to the Media but not the way many of you do. I listen to the media and when I see them catching onto a trend, like Cramer/Macke pushing solar every day (on NBC/GE, the "green" network) I get suspicious. When I see the banks get savaged by bad news, then sold off to five year lows and THEN attacked by the media, especially when some so-so analyst like Meredith Whitney is suddenly raised to the rank of financial messiah - THAT’S when I make my contrary bets.

I don’t, of course, just arbitrarily go negative - a lot of people now think GM sucks, and they do! But when Kirk Kerkorian said he had a plan to bail them out and the stock went to $37 in mid ‘05, reversing a clear downtrend that had cut half their value since 2004, I was one of the only people to cry Shenanigans (and got death threats and called a communist for my troubles). We all did well on Apple (NASDAQ:AAPL) when that got beat up and Google (NASDAQ:GOOG) as well, but that’s because they ARE good companies and the only reason they sold off is because the bears and their hyenas whip the media into a frenzy and stampede the mob out of good stocks for no reason. Learning to identify this behavior is the key to that almost mythical concept of buying low and selling high.

After I read through the hate mail I got after my first quick repudiation of Whitney’s call that CitiGroup (NYSE:C) was going to fall another 50% from their March lows around $20 (a stance, admittedly, I took without feeling I had to check my figures on because her assumptions were so ridiculous), I then felt compelled to lay out the positive case for C that weekend, when I had some time to double-check my assumptions. I won’t rehash it here and I’m not going to go into that level of detail for other banks I like, but just understand that we take an LTP play like this simply on the basis that a firm like C, which is 60% off their highs in one year, simply isn’t going to go down to 0.

CitiGroup is, of course, already up 20% from where I took my stand but, even now, the C 2010 $25s are $5.57 ($4 in premium) and you can sell May $27.50s, WHICH ARE 5% OUT OF THE MONEY, for .50, which is 12.5% of your premium in one month out of 20 you have to sell. If Citibank drops $10 from here (40%) it would cost me about $4 to roll down to the $15s (you need to look at the cost of rolling from the $35s to the $25s, not the cost of rolling from the $25s to the $15s) at which point I would double down (assuming I still believe they won’t go bankrupt), giving me a basis of $7.57 on a $5.57 2010 $15 call (roughly), which would mean I have $6 in premium to work off with 18 sales at .50 each ahead of me.

So it’s great to catch bottoms, but you don’t have to hit it on the head. If you scale into positions, even a tragedy like C could work out for you. (I've expanded the month-by-month blow-by-blow here.) As C moves up in prices, this means that we gain penny for penny with upside movements while our callers do not, meaning we can never lose out to the upside.

On a big gain, our 20 2010 $20s can be rolled to 40 2010 $30s, almost the full amount of calls we were originally hoping to purchase back at our original strike for 40% less than we planned to pay - Not a bad accomplishment for 6 months of work! Why are the C $2010 $25s at $5.57 with 18 months to go when my original 2009 $30s were $7 with 13 months to go when the stock was $5 higher? Sentiment and implied volatility! Right now, both are fairly low but a resurgence in the financials can give us another 20% boost on our leaps (and the calls we sell against them) without much of a move in price.

So now is still an excellent time to buy C and several other financials that A) we don’t think will be going out of business and B) we don’t mind following down by buying in intelligently and covering adequately. I never mind dealing with a stock that goes up farther than I think and puts my callers into some money. Over time, 90% of those work out just fine. As long as we’re comfortable with the downside, as you can see from the above, our risk can be managed very effectively!

In addition to Citi, the following are interesting to me:

Bank of Montreal (BMO) - These guys pulled a nice magic trick and restructured their paper, not taking a $500M hit last Q but that caused 2 lawsuits with a $1Bn overhang. They have no options but I would buy the stock if they retest $45 as I don’t see the suits holding water since many debtholders are getting nothing and BMO did their best to make sure everyone got paid.

Hudson City Bancorp (HCBK) - Zacks is down on them so they’ve been down, but this home-state bank of mine is the 3rd largest savings bank in the US with 25% growth in Q1 with a portfolio centered in the affluent Northeast. They only have 120 branches so your risk is that the NY, NJ and CT housing market falls apart but, if that happens, you can kiss the rest of the country goodbye anyway. Hudson wrote off just 0.01% of their $24Bn portfolio vs. 1.25% for BAC and 2.24% for WM (who I like anyway). Q1 loan applications were UP 78% as their cheaper competitors closed up shop last year.

I like the Oct $17.50s straight up for $2.55 (.90 premium), we can sell current $17.50s if we get in trouble or the $20s over .60 but, otherwise, it’s a straight play as far out as we can go. You can also own the stock for $19.11 (2% dividend) and pick up $2.53 selling some other sucker the Oct $17.50s, which drops your basis to $16.56 and a sale at $17.50 would be a 5.6% gain in 6 months, not terrible.

ICICI Bank Ltd (NYSE:IBN) - I’m confused, is India over or just old news or the most exciting growth opportunity of the 21st century? It depends which meds Cramer takes on any given day I think… IBN’s biggest problems is they are too honest, unlike many foreign banks, they run the British-style system of just booking their losses, saying they’re dreadfully sorry and moving on. Lloyd’s gets killed for this every once in a while as well (yet they’ve been in business for 300+ years). Last quarter, India’s largest private bank lost $264M (9% of the year’s profits), again this is on $250Bn in annual revenues which was a $100Bn gain over 2006 (66%) which had been a $50Bn gain over 2005 (50%). ARG in a bank??? Who is selling this thing?

If you are looking for stability, Russian roulette is a safer play but I think they are safely over $45 (earnings should be out this week) and there is nothing wrong with a small start on the Jan $40s at $11.90 selling 3/4 June $45s for $4.90 for a net outlay of $8.22 per contract, less than the cost of the Jan $45s (should we drop $5) selling $2.02 per leap in premium, which is 1/2 our total premium to the upside. This is an easy roll up even to 2x the June $50s so we want to have money to buy another 3/4 our longs in Jan $50s, now $6.65 so we can do the roll-up if it goes that way.

Royal Bank of Scotland (NYSE:RBS) - You’ve seen the ads, now buy the bank! They bought part of ABN Amro for $10Bn and took a $1Bn hit in writedowns and now they are doing a dilutive $12Bn raise to get their capital ration back over the 5.5% that is normal for UK banks (now 4.25%) . They are thinly covered by analysts but have serious growth and make about $1.50 per $7 share so these are going in my stock portfolio with a 10% entry and I’ll buy 10% more at $6 and 10% more at $5 and DD at $4 (60%) if I have to (unless there is new information that makes this seem like a bad idea). In March they paid a .46 (5%) dividend and I think that is normal for them. If we don’t go down and we get past the capital raise, I’ll buy 10% more at $7.50 and 10% more at $8, which would put me in at $7.50 with 30% of my intended entry up .50 already so nothing to complain about there…

Washington Mutual (WM) - Another bank on Meredith’s hit list! You’ll notice the aggressive banks get attacked by all the analysts from the companies that aren’t growing - imagine that… WM has it all for me, off 75% from it’s highs, 2,500 locations, already taken out back and shot, stabbed, poisoned, hung and drowned while someone just gave them $7.7bn in capital at $8.75 per share, putting their book value at right about $12. They made $3.4Bn in ‘05 and $3.5Bn in ‘06 and lost $67M last year, dropping their market cap from $44Bn to $11Bn. Now dilution is BS used by the Whitney’s of the world to confuse you. You are buying a share of a bank at a value of $11Bn and, when not screwing up with bad loans that they have to write down (meaning they will pay no tax for a year or two) they make $3.5Bn, that’s $3.50 back on each $11 worth of the bank you own, regardless of the share price. They started ‘07 with $319Bn in assets and finished with $327Bn in assets and, despite the $1.9NBb Q4 loss (paper), managed to generate $2.6Bn in free cash flow.

These guys do have an active option trade and 4/15 earnings were a beat (low expectations) so I like the 2010 $10s at $4.90 ($2.30 in premium) selling the $13s for .50 fully covered. If they go up, we buy more longs, if they go down, we sell lower but the roll to the June $14s is even at the moment and, if the stock gains 10% in 45 days, paying off our caller won’t really make us cry.

XLF - If write-down roulette doesn’t appeal to you, the ETF for the financials (NYSEARCA:XLF) is the way to go. They are 20% off the bottom and 1/3 off the top (we’ve been in since the bottom) but, best of all, they have options in $1 increments to roll and roll and roll using the old .40 per $1 rule (you roll yourself down for .40 per $1 whenever you can, this keeps you at the right strike and pays $1 for every .40 you spend on the way back up). That works with the ’09s but not the 2010s so, for the sake of simplicity, well say the Jan $26s are the right place to start at $3.23 ($2.30 premium) and we can sell 1/2 the $28s at .60 (10% for 2 weeks!) or the full cover the $27s at .60 (20% for 2 weeks) if it goes the wrong way. Since it only costs us .60 to roll down to the $25s, we are good for a 10% drop!

Note that the XLF is not really banks but includes BAC, C, WB, WFC but also AIG, AXP, GS, JPM. If the economy doesn’t collapse, this group could be the deal of the century!