Financial Stocks: In the Money?

Shares of banks, brokerages, and commercial lenders could take off in a strong recovery. The key is picking those with staying power

By Emily Thornton

The stock market scandals that dogged the big brokerages last year aren't quite history yet. But mortgage refinancing is still going gangbusters, thanks to record-low interest rates. Investment banks helped companies issue more stock in May than they had in any month in almost a year. And long-awaited signs of life emerged in the merger business on June 6, when Oracle bid $5.1 billion for PeopleSoft.

With so much optimistic news, it may be time to reassess shares of brokerages and banks. But savvy investors will tread carefully. Many stocks in this sector have already had significant price runups over the past few months. JP Morgan Chase (JPM ) has soared 52% since Mar. 1, trading now at around $34.30 a share. And despite all the rumors of scandal that plagued big houses like Citigroup (C ) and Merrill Lynch (MER ) last year, drops in their valuations really weren't all that dramatic. Most investors saw them as major players that were never really going away.


  The trick will be figuring out the long-term winners. "Would I still be buying brokerage stocks? Yes. And we are," says Michael Holton, manager of T. Rowe Price Group's financial-services fund. Holton sees "valuations, relative to historical averages, [that] look reasonable."

Some analysts and money managers think the stand-alone investment banks are best-positioned to gain in an economic rebound. They're switching their money to big equity underwriters and traders such as Morgan Stanley (MWD ), Merrill Lynch, and Goldman Sachs (GS ) and away from debt champions such as Bear Stearns (BSC ).

Though brokerages have posted only so-so earnings for the second quarter, some portfolio managers are betting that they'll jump in value longer term, once the economy is firmly on the road to recovery. Guy Moszkowski, Merrill Lynch financial-services analyst, sees "a lot of upside" in Morgan Stanley. He estimates that it could rise -- from trading at half its stock market price-to-book ratio to three quarters -- if companies start to issue a flurry of equity.


  Many pros still like Citigroup, which at $43.42 a share is already near its 52-week high of $45.72. They figure the financial giant might pay out more earnings in dividends. That's much more attractive to investors under the new tax law, which has cut tax rates on dividends. "Citigroup is best-positioned to do that because it has a lot of businesses that generate excess cash flow," says Henry McVey, financial-services analyst at Morgan Stanley. He estimates that Citigroup could lift its dividend per share by as much as 50%, to $1.20, in July.

With commercial banks, the name of the game will be picking outfits poised to benefit most from higher demand for corporate loans. "Commercial credit may also finally be improving and could provide upside for some large banks," says Andrew B. Collins, financial-services analyst at U.S. Bancorp. That could serve as a buffer to banks' contracting net interest margins -- the difference between the interest rates that retail banks charge their customers and what they themselves pay to borrow money.

Although shares of J.P. Morgan Chase, Bank of America (BAC ), and U.S. Bancorp (USB ) have soared this year, many money managers haven't stopped buying. That's because they believe that these outfits have cleaned up their commercial loan books more than most investors realize.


 Others seek seeming havens such as Wells Fargo (WFC ). "We think Wells Fargo's strong consumer franchise has less risk," says William Batcheller, a portfolio manager for the Cleveland-based Armada Equity Growth fund. "A higher proportion of Wells's consumer finance tends to be secured loans, and it has a strong mortgage business." It's now trading at around $51 a share, $54.74 being its 52-week high.

More daring investors are snapping up shares in banks they think are possible takeover targets. Such stocks will command a premium if stronger players such as Bank of America or Bank One (ONE ) go on the prowl once the economy recovers. Potential targets include Pittsburgh's PNC Financial Services Group (PNC ), Atlanta-based SunTrust Banks (STI ), KeyCorp (KEY ) in Cleveland, and Beantown's FleetBoston Financial (FBF ). "I think this is the year of the big deal," says Anton Schutz, manager of the Burnham Financial Services fund, who believes the industry is presently weighed down by overcapacity.

Guessing takeover plays may be too nerve-racking for most investors. And the risk exists that financial stocks will ride a roller coaster on the way to recovery. But for those who believe that eventually companies must raise money to invest in their businesses, this may be the time to grab shares of the banks and brokerage outfits that will supply that money.

Thornton is Finance & Banking editor for BusinessWeek in New York

Edited by Douglas Harbrecht

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