Bargains in Banks
On the heels of a 280-point plunge, bargain hunters stampeded Wall Street on August 29, sending the Dow Jones Industrial average up 247 points, or almost 2%.
If you've been whiplashed by the stock market's volatility recently, we wouldn't blame you for cursing the mortgage market, with all of its poor-quality loans and abstruse derivative securities that give us all headaches. But if you're looking for bargains, too, you might do well to head right back to the mortgage arena to look for beneficiaries of that market's shakeup.
Big regional banks that have always focused on good-quality loans and kept their underwriting standards high won't suffer the loan losses that lenders with lesser standards will. And the banks stand to gain customers in droves -- not only because the mortgage lending field is shrinking, but also because borrowers may prefer getting their mortgage money the old fashioned way: from a bank with a branch on the corner.
"Literally thousands of competitors -- many quite large -- are going to go away," says analyst Gary Townsend at Friedman Billings Ramsey & Co. The August 20 shuttering of Capital One's GreenPoint mortgage arm is a case in point.
Yet the stocks of strong, healthy banks have been hammered right along with the subprime lenders that deserve it more. Investors possess a buying opportunity that is definitely worth exploring. "The sector really has been hit this year, but some of the concerns are overblown," says Lisa Welch, portfolio manager of John Hancock Regional Bank fund, who says she's been bargain hunting recently.
Bank stocks are trading at about three-quarters of the price-earnings ratio of the market overall, while earnings will grow apace with the market. In fact, financial stocks have the lowest P/E of the ten sectors represented in the S&P 500.
FBR analyst Townsend says Wachovia (symbol WB) has one of the most bullet-proof residential loan portfolios. Most of the loans (84%) are first trusts. Holders of such loans are less likely to default, and lenders are first in line for the collateral if they do.
Wachovia boasts one of the lowest charge-off rates among its competitors, just 0.06%. What's more, Wachovia keeps most of the loans it originates, so it doesn't have to struggle to sell home loans in the extremely volatile secondary market. The company recently reported an increase in loan applications and lower pre-payment activity.
The truly tasty icing on the cake is a generous 5.2% yield. Wachovia closed at $48.49 on August 29, up 1.2%. The stock is trading at just nine times Townsend's 2008 earnings estimate of $5.33 a share-quite the bargain when you consider that he thinks the Wachovia shares could see $60 within a year.<
b>Bank of America (BAC) does not make subprime loans -- those to less-than-credit-worthy borrowers. So it has rock-bottom 0.05% charge-off rate for residential home loans. The company's strong balance sheet allows it to be opportunistic, growing despite the market mayhem. The recent $2 billion investment in struggling Countrywide Financial (CFC) is a classic example.
Along with Wachovia, Bank of America raised its dividend in the summer of '07, and yields a hefty 5.0%. The stock, which gained 1.8% on August 29 to close at $50.55, trades at just ten times the $5.23 a share Townsend thinks the company will earn next year. He sees the stock at $58 within 12 months.
If you want a couple of bargains in the financial sector with little at all to do with mortgages, take a look at PNC Financial Group (PNC) or U.S. Bancorp (USB), each with less than a fifth of assets in residential real estate loans.
The banks have the added appeal of exposure to businesses that are not particularly dependent on the direction of interest rates. PNC handles accounting and other back-office processing for mutual funds and hedge funds, while U.S. Bancorp manages corporate trusts and processes retail transactions. PNC closed at $70.72, up 2.5% U.S. Bancorp closed at $32.31, up 1.6%.
Selectivity is key within this volatile, dicey sector. Townsend warns investors away from banks with high residential loan charge offs or substantial mortgage portfolios -- especiallyif the loans are predominately second liens or home equity loans. Among those he'd avoid: Fifth-Third Bank (FITB) and Suntrust (STI). He rates National City (NCC) and First Horizon (FHN) as "holds," but mortgage woes will remain a headwind to earnings, Townsend says.
And credit worries could easily spread from the mortgage sector. "Now there's speculation as to whether we'll see some fallout in the credit card area as consumers, strapped for cash, continue to use credit cards for mortgages or other loans," says analyst Eva Weber at Aite Group, a financial services consulting firm.
But banks that have been prudent underwriters will prevail, says portfolio manager Welch. "Unless we have a really long and deep recession, costs will be manageable. In that environment, the Federal Reserve will cut interest rates. And history show that bank stocks have done well when the Fed starts to lower rates."
Considering that the odds are in favor of a rate cut when the Fed meets September 18, this may be the time to strike.