It's been a tough year to like financial stocks. When the Fed is engaged in an interest rate hiking cycle, the financials tread water at best. I'd be willing to bet that I have sacrificed several percentage points of performance so far this year from holding a decent chunk of them.
That's the short-term view though, and the longer term view is the one I can't help but focus on. There are some great financial services companies out there and the valuations are way too low, below the market's 16 P/E in most cases. Over the next few weeks and months, they might continue to flounder, but if you look out 2 or 3 years these stocks are going to make people a lot of money, and they often pay huge dividends to boot.
Excuse me for keeping many specific names closely held (after all - this is a free site, as opposed to my paying clients) but I have written about Capital One (COF) on this blog before. That story remains very bullish and the stock trades at less than 10 times forward earnings.
Another one I have yet to mention is E*Trade (ET). Most people think of them purely as a discount brokerage, but they have branched out and now offer banking and lending services as well. In fact, only about a quarter of their revenue is generated from stock commissions. The shares sell for $12 each and trade at only 11 times 2006 earnings.
Morgan Stanley's Purcell To Stay, For Now
The TradeSports contract on whether Phil Purcell would be fired or resign as CEO of Morgan Stanley by June 30th was always overpriced, representing a great opportunity for traders who wanted to short it. It has been widely speculated that Purcell would be ousted in the latest battle to get Morgan back on the path to respectability.
The only problem was that the company required 75% of its Board to vote Purcell out, which equated to 10 of its 13 members. The presence of Purcell and two of his buddies (who found themselves there exclusively because of him) made it extremely unlikely he would be removed by mid-year. That would require each and every one of the remaining Board members to vote to boot him.
CNBC's Maria Bartiromo reported late Friday, after a report was first published in the Wall Street Journal, that a Board meeting would take place over the weekend in Chicago, sparking speculation that Purcell's reign was over. The TradeSport contract doubled in value to 50 cents in no time, yet another shorting opportunity.
Word came Sunday that rather than fire Purcell, the Board would change its bylaws to require only a simple majority, or 7 out of 13, to replace him as CEO. The contract tumbled 70% to 15 cents. It appears Purcell will get a chance to spin off the Discover credit card unit and try and bring the company back. If he continues to prove unsuccessful as a Chief Executive, you can bet it won't be very difficult to get 7 "yes" votes to force him out.
As for the stock, it's cheap at $52 and might fall back to the $49-$50 area on news that Purcell is staying put. Value investors should use any weakness to add shares. Very few scenarios will cause the situation to get much worse. Either Purcell starts doing his job, the company gets sold, or someone new comes in to lead Morgan in a new direction. Any and all of those options will increase shareholder value from here.
Capital One Can't Hold Gains After Upgrade
Shares of Capital One (COF) opened up more than $1.00 this morning, were up more than $2.00 at one point, and now are unchanged after an upgrade to "buy" from Goldman Sachs today. Oftentimes an upgrade will keep a stock up throughout the day, even when the overall market tanks. Not today, though.
One reason might have to do with this Goldman analyst's track record on COF stock. The analyst, Michael Hodes, last had a "buy" on Capital One more than 2 years ago. The stock began 2002 in the 50's and fell to $30 per share by October of that year. Hodes pulled his "buy" rating at $30 and has held to that neutral opinion ever since.
Now trading at $75, Hodes upgraded the shares to "outperform" this morning. Goldman clients must be ecstatic. If analyst ratings were supposed to tell investors how the stock has done in the past, then Hodes' new rating would make sense, as the stock has indeed outperformed, rising 150% in the last 30 months. Too bad that's not what he's supposed to do.
Raising Rates Like It's 1994
The parallels between 1994-1995 and 2004-2005 are quite striking when it comes to the Fed's interest rate policy and the stock market. History tends to repeat itself in the financial markets, and if indeed today's situation plays out like it did a decade ago, short-term pains could very well reward investors with longer term gains.
First, let's recap how the 1994-1995 period took shape. The stock market rallied nicely in 1992 and 1993 as rates fell and corporate earnings showed healthy gains (not unlike 2003-2004). Chairman Greenspan and the Fed began raising interest rates in 1994, using 7 rate increases to take the Fed Funds target from 3% to 6%. Rather than moving gradually and telegraphing its intentions, the Fed moved very quickly, including two increases of 50 bp and one move of 75 bp.
Many were not prepared for such rapid rate hikes, and as a result, Orange County CA, the Mexican Peso, and Wall Street firm Kidder Peabody spun into crisis. Stocks tumbled throughout much of 1994, dropping by more than 10% at one point. However, a late year rally got the market back to about break-even for the year. The last rate increase came in January of 1995. Once the Fed stopped, the stock market rallied strongly for the duration of 1995, finishing the year with a 37% return for the S&P 500.
Could this time play out similarly? Ironically, the Fed's recent 25 bp rate hike, to 2.75%, marked the 7th rate hike since last year. A similar move to 1994 (300 bp from the lowpoint) would put interest rates at 4% when all is said and done, as the Fed Funds rate bottomed at 1% last year. Much like 1994, stock prices have struggled this year as rate increases are showing no signs of letting up.
The similarities are too noticeable to ignore. The Fed has acknowledged that it raised rates too quickly in 1994-1995 and therefore has chosen to move more slowly and steadily this time around. Whenever they decide they have stifled inflation enough, I wouldn't be surprised to see the 1994-1995 scenario continue to play out, with the stock market finally able to make meaningful headway to the upside. Until that happens, 2005 could very well play out just like 1994; painful short-term, but paving the way for gains later on down the road.
As for specific investment strategy, it's not surprising that financial stocks have struggled since the Fed began raising rates. This trend is likely to remain intact as long as Greenspan continues his current course of action. However, financial services stocks are getting very attractive on a valuation basis. Waiting for the last rate hike before buying them will cause one to miss part of the move upward when the Fed is done, since the market will anticipate it ahead of time.
Adding some bank stocks as the tightening cycle winds down should prove very profitable for investors. Check out the chart below of Citigroup from the aforementioned 1994-1995 period. The Fed stopped the rate hikes in early 1995, leading to a huge move in the group.
GE Capital Pulls GM's Credit Facility
Yields on General Motors (GM) long-term corporate bonds jumped to over 10% in early trading this morning on news that GE Capital has pulled its credit facility. The bonds have rallied slightly off the lows, as traders take into account GM's various other sources of liquidity.
Other notables:
Electronic Arts (ERTS) is down $9 after warning on 2005 EPS and projecting 2006 profits would be roughly flat year-over-year. Although the shares are getting slammed today, the valuation still doesn't look all that compelling.
Martha Stewart Living (MSO) is nearing my $20 target price for taking profit on the Sep 05 $45 puts. I don't think the stock looks attractive here, but at some point you just have to take your money off the table to avoid being too piggish. If there was any stock available to borrow (there isn't), I'd like to short it with some of the put option proceeds.
Morgan Stanley Analyst Understands COF
You won't find me praising Wall Street analysts very often, but sometimes investors can find a diamond in the rough here and there. Morgan Stanley's upgrade of Capital One (COF) this morning, following the lender's announced buyout of Hibernia (HIB), warrants such praise. The analyst raised the rating on COF to buy from neutral.
An upgrade in and of itself never gets me too excited. The next thing I look at is the particular analyst's track record with respect to that individual stock. After all, if they've been dead wrong on a company for years, why should one all of the sudden listen to them now? A little research finds that Morgan Stanley last put a buy recommendation on Capital One shares on May 12, 2004. This bodes well for investors, as you can see from the chart below.
After getting hit hard in early May of last year, Morgan came out and pounded the table when others were fleeing the name. The buy recommendation at $63 was the right call, and I'd be willing to bet few other analysts were making the same conclusion at that time. It looks like we can add the Morgan Stanley's Ken Posner to the list of relevant Capital One analysts.
Capital One to Buy Hibernia
Investors who closely follow Capital One Financial (COF) shouldn't be very surprised to hear that the company has agreed this weekend to buy New Orleans-based Hibernia Corporation (HIB), a bank with over $22 billion in assets, for $5.3 billion in cash and stock. The writing for a deal like this has been on the wall for a while. Capital One, which focuses on marketing directly to customers, is seeking to boost its reach by acquiring a regional bank, opening up new avenues for growth.
From an investing standpoint, it makes little sense to bet against Capital One based on this acquisition. The company is run brilliantly, having increased earnings per share at least 20 percent every year since its IPO in 1994. Wall Street will likely sell off COF shares tomorrow, given the company is paying a 24% premium and many will likely question the decision for a direct marketing lender to spend over $5 billion for a bank with branches in Louisiana and Texas.
In such a case, investors who have missed out on Capital One's magnificent track record thus far should consider stepping up to the plate and buying the stock on any merger-related weakness. The stock trades at only 11 times 2005 earnings, and that valuation will only get more compelling should the stock get hit tomorrow. And who knows, an analyst downgrade or two might spark enough of a sell-off that existing shareholders, such as myself, should consider adding to their positions.
Capital One Shares Crushed After 4Q Report
After blowing earnings estimates out of the water for the first three quarters of 2004, Capital One (COF) fell short last week when it reported fourth quarter profit below the consensus estimate. Shares of COF were slammed, falling 5% after the announcement. The stock also saw analyst downgrades after the earnings miss, much to the delight of shareholders, I'm sure.
The earnings miss was mostly attributable to higher than expected marketing expenses and more money set aside as loan reserves. While Wall Street seems to see this combo of unexpected news as a warning sign, that conclusion makes little sense. While seen as a financial services firm, Capital One is just as much a consumer marketing company. The better job it does of marketing to the public, the more loans it can make, and the more money it pockets.
Unless the advertising dollars were failing to provide an adequate ROI, Capital One's $511 million in marketing spend for Q4 (which was more than Citigroup and JPMorganChase) will allow it to continue its rapid growth, hardly a bad sign. Higher loan reserves don't indicate more difficulty in collecting debts, as some are quick to conclude. Rather, more loans outstanding require higher reserves, even when the default rates on such loans remain the same or even decline.
In the mid seventies, COF shares trade at 11 times 2005 earnings. Not bad for a company that has grown earnings per share 20 percent annually since its IPO.
Metris Continues Its Turnaround
Credit card issuer Metris Companies (MXT) continue to be a stellar performer in 2004. Shares of the once financially troubled firm have tripled this year from $4 to $12, greatly contributing to Peridot Capital's success year-to-date. The stock pulled back to $10 after an analyst downgraded the stock, citing full valuation.
However, the shares have moved back toward the old highs as news of early debt repayment and refinancing of existing debts hit the wires. In addition to the strong operational turnaround orchestrated thus far, any interest expense reductions the company is able to secure, based on the improving performance of its loan portfolio, will serve as yet another catalyst for incremental earnings gains going forward.
With some analysts still bearish on the company's future, combined with a staggering 24% of the float sold short, there are many reasons to think that Metris shares will continue their march higher in 2005. Contrary to popular belief, it's not too late to get in, even at the current $11 price tag.