Gene Marcial talks to investors who believe opportunities remain amid the wreckage at the Wall Street financial houses
It has been a rough few months for America's vaunted financial institutions, which are under siege. As the mortgage debacle has spread, banks and Wall Street investment houses have seen their stocks crash after they disclosed billions of dollars in losses, and the chief executives at Citigroup (C) and Merrill Lynch (MER) have stepped down. Many experts predict more pain ahead. On Nov. 19, analyst William Tanona of Goldman Sachs said that Citi may have to take writedowns totaling $15 billion over the next two quarters, while he also lowered his price targets on seven financial stocks. There may even be more CEOs who find themselves out on the street (BusinessWeek.com, 11/14/07).
But are there investment opportunities amid the wreckage? Some investors think so. They're diving right in and gobbling up shares of the financial houses at the center of the maelstrom, including Bank of America (BAC), Citigroup, American International Group (AIG), JPMorgan Chase (JPM), Merrill Lynch, and Morgan Stanley (MS). "We are buying them all," says David Katz, chief investment officer at Matrix Asset Management, a New York money management firm with assets of $1.6 billion.
Are Katz and other money managers playing with fire? There certainly are risks. But the rewards to confronting the risks look compelling, given the financial firms' steep fall. As of Nov. 19, Citigroup is down to $32.50 a share from its 52-week high of $57 on Dec. 28, 2006. Bank of America is at $43.15, down from $55.08 on Nov. 20, 2006. AIG is at $55, down from $72.97 on May 11. JPMorgan is at $42, off from its high of $53.25 on May 9. Merrill Lynch tumbled to $53.50, from $98.68 on Jan. 18. And Morgan Stanley dropped to $51.16 from $75.50 on June 15.
The Case for Buying
The argument for buying is not that these companies won't have more problems. Perhaps some of them will. But Katz and others believe that, as a group, these giant finance companies play such a central role in the economy that they'll continue to have bright prospects. "We aren't playing with fire, because these companies are the biggest and the best players in finance and investments, with tremendous, diverse resources and clean balance sheets," says Katz.
These stocks are now priced as if there has been a permanent impairment in their earnings power. While the subprime problem is still a major concern, Katz is convinced many of the financial institutions are getting closer to cleaning up the mess. "They have the financial wherewithal to exit this period with strong balance sheets and prospering businesses," says Katz. Their stocks are selling at the low end of their 6- and 10-year valuation ranges in terms of their price-earnings and price-to-book ratios.
To be sure, there are still plenty of financial stocks that don't look like bargains, despite their battered stock prices. Those closest to the mortgage mess appear to have the most risk, if the housing downturn continues. "We are wary of companies whose main businesses are in the subprime market or mortgage lending, and whose exposure to mortgage loans constitutes their main source of income," says one New York investment manager who, otherwise, has been buying diversified financial-services companies.
Among the stocks to avoid: Washington Mutual (WM), the largest U.S. savings and loan association, which Standard & Poor's rates a sell; Countrywide Financial (CFC), which originates, buys, securitizes, and sells service mortgages; and Ambac Financial Group (ABK), the second-largest municipal bond insurer. Also unattractive because of the risk and uncertainty surrounding them are investment bank Bear Stearns (BSC) and the Federal National Mortgage Assn. (FNM), known as Fannie Mae, a government-sponsored enterprise that buys mortgage assets from other lenders.
Two Picks: AIG and BofA
Stock buybacks are one thing making companies like AIG attractive to some money managers. The insurance giant has raised the amount of shares in its buyback program to take advantage of the stock's depressed price. Katz believes AIG's stock will hit $85 in a year. While the company took a $3 billion loss in the third quarter, it expressed a high level of confidence that it can, with its financial strength (it has an equity base of more than $100 billion and excess capital of $21 billion) make future investments and take advantage of the depressed prices in mortgages and other fixed-income areas.
Katz counts Bank of America as one of the "lower-risk" stocks in the group because of its strong balance sheet and rock-solid dividend, which it recently raised. "Bank of America will come off the subprime problem still in great health and in good form," says Katz.
He isn't alone in his bullishness towards the financials. On Nov. 19, analyst Tobias Levkovich of Citigroup upgraded the U.S. banking sector to "overweight," arguing that negative sentiment about financials had created a buying opportunity. S&P rates AIG a buy as of Nov. 10, with a price target of $74. On Nov. 4, Goldman Sachs (GS) put out a buy recommendation on AIG, with a 12-month price target of $87. "We would remain aggressive buyers of the shares," says Goldman analyst Thomas Cholonoky.
Goldman Sachs is also still bullish on Bank of America, which it rates a buy. It argues that the company is focused on using its scale and capabilities to penetrate the mass affluent market. Its premier banking services currently reach only 13% of the mass affluent customers who are already retail banking customers, says Goldman's Lori Appelbaum, who has a 12-month price target of $57. While the broader credit concerns are clearly the primary issue for the stock now, she says wealth and investment management is a small but important driver of growth long term. S&P is also high on Bank of America. In a Nov. 10 analysis, S&P's Frank Braden says BAC offers an attractive risk/reward ratio at current valuation levels and an above-peer dividend yield of 5.2%. He says nonmortgage consumers, large market commercial lending, and market-sensitive fee-based businesses will drive revenue growth in 2008.
Sifting Through the Subprime Rubble
On Citigroup, Katz of Matrix expects its stock to hit $55 to $60 a share in a year. While it has real problems in subprime and collateralized debt obligations, "we are confident its more than $120 billion equity capital base will allow it to muddle through the credit issues without impairing the long-term earnings power of the company," says Katz. In a recent statement, Citigroup made the point that while it was taking substantial mark-to-market writedowns, the accounting issues did not affect the company's robust cash flow.
With regard to Merrill Lynch, Katz considers the appointment of John Thain as its new chairman and chief executive (BusinessWeek.com, 11/14/07) very positive news. Thain, formerly chairman and CEO of NYSE Euronext (NYX), which owns the New York Stock Exchange, brings Merrill Lynch tremendous skills that the No. 1 brokerage house needs to recover quickly and to get back to its growth plan for the long term, says Katz. Merrill's stock is down some 40% this year. The change at the top will help it refocus the company on improving shareholder value, says Katz, who has a target price of $82 to $85 in a year.
JPMorgan is one that has escaped the brunt of the fallout from the mortgage crisis. JPMorgan Chairman and CEO Jamie Dimon "is doing a great job, with full control of the situation because he fully understands risks and how to manage them," says Katz. He thinks the stock, now at $43, is worth $58. S&P is also sanguine on JPMorgan, rating it a buy, with a 12-month target of $58. S&P's Braden says JPMorgan has solid growth prospects and diverse geographic product lines. The dire results in its mortgage banking, auto-financing, and leveraged loan business will act as a near-term drag on earnings, he acknowledges. But its large customer base, says Braden, and its strong fundamentals will give JPMorgan the flexibility to move toward higher growth products and markets, as well as absorb potential challenges that may lie ahead.
At Morgan Stanley, the loss it reported was disconcerting, but Katz figures its subprime exposure is manageable. Outside of its fixed-income operations, all the other businesses, including mergers and acquisitions and international activities, remain very profitable. Katz still expects Morgan Stanley's 2008 earnings will be at, or above, all-time highs. So he figures the stock, now at $52, could hit $72 to $76 in a year.
It is worth noting that these financial institutions have huge capital bases and diversified books of businesses. While some of them have taken billions of dollars in write-offs, their core businesses continue to be very profitable. The intensive selling that hit these stocks have produced compelling and timely investment opportunities.