A Few Gems Amid the Financial Ashes

A Few Gems Amid the Financial Ashes

Everyone knows the financial-services sector has been a train wreck, with subprime disasters causing billions in earnings writedowns and sending financial stocks down 21% in 2007.

Since then, the stocks have remained volatile, shooting up 16% after the Federal Reserve cut interest rates by 0.75% on Jan. 22, only to cede almost half that ground in the first few days of February. It can take courage to venture into such a scene, but some big-name investors see pockets of value in the wreckage.

The smart-money set's interest highlights the fact that many stocks and bonds are probably mispriced and tarred by the fear and loathing surrounding all financial assets. That means, depending on how much risk you're comfortable with, this may be a good time to stake out areas of the market that offer rewards attractive enough to compensate for the very real dangers that still exist.

Investors testing the waters include Bill Gross, manager of the world's biggest bond fund, the $112 billion Pimco Total Return Fund. Gross says he's swapping Treasury bonds for debt issued by Citigroup (C), Bank of America (BAC), and Wachovia (WB). Also dabbling in the sector is 71-year-old value manager David Dreman, who says the stock market is in the midst of a "classic panic." Dreman has increased his Bank of America and Wachovia holdings while adding shares of other "strong companies" in the financial sector that he's not ready to name yet.

If a late-January investing conference sponsored by Citigroup is any indication, more investors may jump in soon. Financial-services company executives made their pitches to standing-room-only gatherings in the ballroom of New York's Waldorf Astoria. "Everybody's crowding around now," says David Ellison, manager of several financial sector funds for FBR Funds. "The dangers are being mitigated by the actions of the Federal Reserve and the rest of the federal government." Ellison, who got his start as a banking-sector analyst under Peter Lynch at Fidelity Investments in the 1980s, says the current mess isn't so different from previous financial-sector blowups. And thanks to ample investment funds piling up in Asia and the Mideast, he notes, there's no shortage of capital for banks in need.

Companies like Citigroup and Merrill Lynch that have had some of the biggest problems with subprime mortgages carry the highest risks. The stocks have hit record and near-record lows when judged by many standard valuation measures. But with the possibility of more losses and write-offs, it's hard to know how much to trust the numbers used in some of those measures. For example, in December, before fourth-quarter earnings reports rolled in, the earnings figure used to come up with the sector's price-earnings ratio resulted in a p-e of less than 10. That compares with a 10-year average of 16, according to Bespoke Investment Group, so the stocks looked cheap. But after lousy fourth-quarter earnings results came out, plugging the lower earnings number into the formula sent the sector's p-e back up to 15.6.

Even more challenging, the past several years saw big banks and brokerages make a killing by selling securities backed by subprime mortgages and other shaky assets. That business has all but dried up. Wall Street sold $18 billion worth of U.S. asset-backed securities this January, down 86% from January, 2007, according to market tracker Dealogic. "A lot of high-quality names look reasonably priced," says Walter McCormick, manager of Evergreen Fundamental Core Large Cap Fund. "But the very biggest are going to have big revenue holes to fill."

STAYING AFLOAT

Not every big name has been dragged down to the same degree. While Merrill's stock has fallen 50% in the past year and Citi's 42%, insurance giant AIG (AIG) has declined 24% and trades at about 10 times its annual earnings per share; its average p-e for the past five years is above 17.

The company said in December that its mortgage investments had lost about $3.5 billion, far less than major banks and brokerages and less than one-half of 1% of the insurer's total assets. "They have minimal subprime, they're well-capitalized, and the stock is in good shape to recover," McCormick says. He and other fund managers have also bought shares of Wells Fargo (WFC) of late, sparking a 30% rally in the second half of January; the stock gave up almost half that advance by Feb. 5. The bank will gain substantial market share in mortgage lending now that many of the smaller players have been driven out of the business, McCormick says. And less competition will mean more profitable lending.

Shares of regional banks may be a much less risky play. The stocks of many of these banks have dropped based on the same fears that hit bigger institutions even though they didn't make many subprime loans. These banks, which have concentrated on more traditional lending activities, are poised to profit from the Fed's sharp rate cuts, which lower their expenses. For example, Astoria Financial is a savings-and-loan based on New York's Long Island that caters to diverse ethnic populations around Manhattan. Its fourth-quarter profits were hurt by the narrow gap between short-term rates Astoria pays to borrow and long-term rates it charges on loans. That's all changed now. FBR manager Ellison likes Astoria, along with stocks such as Washington Federal in Seattle and Hudson City Bancorp in New York. Investors can buy a diversified index of such companies with the KBW Regional Banking Fund, an exchange-traded fund that holds 50 banks from around the country.

TAKING SHELTER?

Fear of financial fallout is also leading to opportunities for some real estate investment trusts (REITs). While many REITs own houses or buildings whose value is declining, some specialize in owning mortgages and mortgage-backed securities. Veteran fund manager Wally Weitz, co-manager of Partners Value Fund, has bought shares of one such REIT, Redwood Trust, that yields 7% even after a 28% rally in its stock price this year. Redwood raised cash and held off on buying loans over the past two years as it felt lenders got too lax, but now the company is jumping back in. It's not alone. Mortgage REITs Anworth Mortgage Asset, MFA Mortgage Investments, and Annaly Capital Management raised a total of $1.3 billion since mid-January to buy up mortgage debt.

If you think credit markets have oversold on panic, you may want to look for bargains in closed-end funds that invest in bonds and loans. Closed-end funds sell a limited number of shares that trade like a stock. That means share prices can fall well below the net asset value of a fund's holdings when too many investors sell in a brief period. And with so many investors panicking at the end of 2007 because of fears that banks might collapse, discounts widened to bargain levels. For example, Van Kampen Dynamic Credit Opportunities Fund, which invests in corporate bank loans, began operations in June, missing many of the shakiest leverage-buyout deals, notes Wachovia closed-end fund analyst Mariana Bush. The fund, which is currently yielding over 10%, trades at a 6% discount to its net asset value. That provides a cushion for investors if the financial-sector recovery is delayed.

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