When it comes to stock-picking, it's not always about finding the best company in an industry. It's about finding the best stock in that industry.
I was reminded of that axiom after poring over first-quarter results from Wells Fargo ( WFC ) , JP Morgan ( JPM ) and Citigroup ( C ) . The first two banks have been the class of the field. Citigroup remains in "clean-up mode" as it emerges from a number of self-inflicted wounds from the lastrecession . Still, Citigroup has potentially much more upside than those better-run banks, which is why it's a member of my $100,000 Real-Money Portfolio .
At first blush, investors are understandably attracted to Wells Fargo and JP Morgan. Warren Buffett has owned Wells Fargo for much of the past decade, rightly acknowledging a solid management team that avoids the worst of the industry's excesses. And JP Morgan is one of the few major investment banks to successfullycapitalize on the weakness seen by rivals such as Citigroup and others.
Citigroup, for its part, has seen its capital base come under focus because it has been slow to shed assets that are no longer core to the bank's future direction, such ashedge fund management. A recent brush-back by regulators after Citigroup applied for permission to boost dividends and buybacks was just another blemish for this erstwhile banking giant. Indeed, Citigroup's need to retrench to shore up itsbalance sheet has led it to now have a slightly smaller revenue base than Wells Fargo, and it's now only two-thirds the size of JP Morgan. Five years ago, Citigroup had the largest revenue base.
Moreover, Citigroup is only slightly cheaper than those other two banks when comparing price-to-earnings (P/E) ratios. In most instances, it pays to pursue an industry's better operator if itsshares are only slightly more expensive. (Arguably, all three of these bank stocks are quite appealing in terms of P/E ratios, as currentearnings are quite depressed compared to what they might be by the middle of the decade.)
Yet in one respect, Citigroup is simply far too cheap to ignore. Shares have risen more than 50% since bottoming out last November, but they still sell at a considerable discount to tangiblebook value .
Even as the stock price has rebounded, so has tangible book value . Assuming that Citigroup is slow to reinstate a more robustdividend , tangible book value looks set to keep on rising at fast pace. (Dividends eat into book value.)
In just the last eight quarters, Citigroup has boosted tangible book value by 31.5%. And that's in a still-weakeconomy . At current trend rates, analysts think tangible book value will approach $60 a share by the end of 2013. As I've noted in the past, stocks can often trade below book on a short-term basis due to near-term investor concerns (in this case, European exposure, which is actually fairly limited for Citigroup). But that gap tends to close over longer periods.
It's also worth noting that the healthier bank stocks trade at a premium to tangible book. Indeed, banks have tended to trade between 1.5 and 2.0 times tangible book for much of the past 30 years.
The subpar valuation for Citigroup implies that the bank has inferior growth prospects relative to Wells Fargo, JP Morgan and others, but that's simply not the case. As I have noted in previous updates, Citigroup has been dedicating a significant amount of resources towards expansion in Asia and Latin America, right at a time when major European banks, which have typically had a strong presence in those high-growth regions, are pulling capital out in order to shore up their operations back at home. Citigroup is getting little credit for these forward-thinking moves right now, but it will.
Risks to Consider: Although Citigroup's exposure to Europe is fairly limited, problems in that region could still weigh on bank stocks in coming quarters.
Action to Take --> A clearcatalyst exists to finally get this stock rolling: Citigroup will re-submit itsfinancial statements for a stress test in June, with a response from regulators due later in the summer. A green light, which is likely will now that its capital base is even stronger than before, should pave the way for a bigdividend hike and/or a large stock buyback plan. Indeed, any time you see a stock selling well below tangible book value, then buybacks should be the preferred choice.
To be sure, Citigroup will need more time to restore its credibility with many investors after needing government support just a few years ago. As long as the U.S.economy grows at a 2% to 3% pace in the next few years, the housingmarket should slowly return to life, which should help boost Citigroup's results. More robust growth that is expected from Latin America and Asia should also help power up thebottom line and punch up book value. For patient investors, the two to three-year returns for this stock could handily exceed 50%.
David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of C in one or more if its "real money" portfolios.
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