TCS Daily


Bank on This

By James K. Glassman - January 15, 2002 12:00 AM

Five years ago I stumbled across a fund I had never heard of with a record I couldn't believe.

Tiny and nearly unknown, it was called First Financial, and its manager, Nicholas Adams, ran a portfolio that had increased in value, including dividends, at an annual rate of 49 percent between April 1991 and April 1996. Over that time, $10,000 grew to $73,000.

One reason First Financial was ignored was that it was a "closed-end" fund -- that is, a fund that traded on the New York Exchange (under the symbol FF) as though it were an individual stock, rather than a conventional open-end mutual fund that investors and their brokers buy directly from a fund house. But like an open-end fund, a closed-end is a group of stocks -- in this case, mainly banks, savings and loans, mortgage companies, and consumer-credit firms -- managed by a professional.

In early 1996, when I initially wrote about First Financial, it was the No. 1 performer among all the thousands of funds -- mutual or closed-end -- tracked by Morningstar. And it continued to dazzle. For the full year 1996, it returned 42 percent; for 1997 (when I finally bought it myself), it returned 41 percent. Then it headed south, falling one-third by the end of 1999. Time to sell? Not at all. In 2000, First Financial returned 28 percent, and last year, a miserable time for the market as a whole, it jumped 47 percent.

First Financial offers three important lessons for investors:

• Stocks never go straight up.

• Selling a good stock after a bad year or two is foolish.

• Well-chosen financial companies can be fabulous investments.

Adams, who has run First Financial since 1986, is a brilliant manager, but even a mediocre stock picker could have done well with financial stocks. At a time when investors were diving into high tech and health care, financials were the great sleeper sector of the past decade.

It's not hard to understand why. The business of buying and selling money -- which, after all, is what banks do -- was a pitifully outdated, inefficient operation until competition began arriving in the 1980s to a sector that had been walled off by regulation. And few industries have benefited more from cost-cutting technology. It's hard to remember life before the ATM or the automated loan applications that take minutes to approve.

The main trend in finance, however, has been consolidation -- and the mergers aren't over yet. The champion of this business is Sandy Weill's Citigroup, with offices in 100 countries and interests in banking, stock brokerage, insurance and consumer lending (100 million credit cards). Citigroup stock has returned a yearly average of 29 percent since 1997, and, even though it's near a 52-week high, it trades at a price-to-earnings ratio of just 19 -- while most stocks today have P/Es well over 20.

For First Financial, Adams looks for companies that are cheaper still. Among the largest of his 83 holdings at last report were Downey Financial Corp., a California S&L (that is, a thrift, or institution that lends mainly for home purchases) with a P/E of 12; Hibernia Corp., a New Orleans-based bank with a P/E of 16; and Doral Financial Corp., a mortgage lender in Puerto Rico with a P/E of 13. While most of his stocks are small-caps (with a capitalization, or stock market value, of $2 billion or less), he also has shares of giant Fannie Mae and of Fifth Third Bancorp, a well-run, weirdly named bank with 1,000 offices in Arizona, Florida and the Midwest.

By the way, Fannie Mae has a business that's almost too good to be true. It borrows money from investors and then provides the money to banks and thrifts to lend to home buyers. Fannie also repackages mortgages as securities for buying and selling on the open market. Fannie's own borrowings carry a low interest rate because of an implicit guarantee that the federal government will stand behind the debt. Last year, Fannie borrowed at an average rate of 6.8 percent and lent at an average rate of 7.5 percent. The "spread" -- seven-tenths of a percentage point -- doesn't sound like much, until you apply it to $700 billion worth of mortgages. No wonder Fannie's stock has more than doubled in the past five years. Freddie Mac, which is in the same business, has done even better.

But conventional banks -- especially small ones -- are where the action is, though few investors seem to be paying attention. So look at a company like BB&T Corp., an exceptionally solid bank chain based in Winston-Salem, N.C., whose stock has returned an annual average of 18 percent over the past five years. BB&T's profits have increased every year for at least the past decade, and its dividend has gone from 23 cents in 1991 to 98 cents last year. Yet BB&T carries a P/E ratio of just 17 and a dividend yield of 2.9 percent (about twice the market average). What's wrong with this picture? Nothing that I can see.

BB&T is one of the top five holdings of John Hancock Regional Bank, the largest bank mutual fund. Since 1985, Hancock has been managed by James Schmidt, another excellent stock picker. Schmidt's other large holdings include two regional bank chains, New York-based North Fork Bancorp (at a P/E of 17) and Cleveland-based Charter One Financial (P/E 13).

Another large fund, Fidelity Select Financial Services, leans toward larger institutions. Its top holdings are Citigroup; Bank of America, which merged in 1998 with NationsBank and now has 4,274 offices in about half the states; American International Group, the giant insurer; and Wells Fargo & Co., the fourth-largest bank of the United States, with earnings that have tripled over the past decade. The fund, which changes managers too much for my taste, has returned an annual average of 19.7 percent over the past 10 years -- though it lost money in 2001.

Meanwhile, Standard & Poor's, the research firm, gives its top (five-star) rating to just five banks: FleetBoston Financial, PNC Financial Services Corp., J.P. Morgan Chase & Co., IndyMac Bancorp and Wilmington Trust Corp., the only one of the quintet with an A-plus rating for earnings and dividend growth. Wilmington, which is Delaware's largest bank, has increased its dividend from 28 cents in 1985 to an expected $2 in 2002, boosting earnings in every year. But it trades at a P/E of 17 and carries a dividend yield of 3 percent.

Bank stocks still seem cheap, and one reason may be the economy. "Bad loans," writes Theresa Brophy, bank analyst for the Value Line Investment Survey, "usually don't peak until recessions are already well under way, and we may only now be seeing the worst of the current downturn." In addition, she says, loans to sectors most damaged by the terror attacks of Sept. 11 -- airlines, hotels, insurance -- "may go bad in the year ahead." Still, it appears that banks are both benefiting from low short-term interest rates and not suffering from the credit-quality problems of past recessions. Maybe lenders learned something from their earlier mistakes.

Still, don't be complacent. Adams, for example, has succeeded by playing the game defensively. He recently wrote to shareholders, "We would still eschew credit risk" -- by owning the stocks of lenders that have not taken big chances -- "and keep concentration levels down." Thus, his portfolio is widely diversified. In fact, his single largest holding is LNR Property Corp., a real estate company (technically, a financial stock) with a P/E of 9. He also has shares in a few brokerage firms, including E-Trade Inc., Legg Mason Inc. and Ugly Duckling Corp., which sells (and finances) used cars.

Another way to play the banking sector is by owning the companies that furnish the technology. Of these, one of my favorites is Jack Henry & Associates Inc., which provides computer systems to smaller banks. While the tech sector is suffering, Henry continues to do well in its niche, increasing sales 53 percent in 2001. The stock trades at a hefty P/E ratio of 35, but earnings have been growing at better than 30 percent annually for the past 10 years. And it's another firm hardly anyone has heard of.

Financials represent about one-fifth the total value of the U.S. (and global) stock market -- and they should claim a similar proportion of your portfolio. Don't neglect strong non-U.S. financials. The T. Rowe Price International Stock Fund, for example, which has outperformed the relevant MSCI index by about 13 percent since 1991, owns large chunks of Royal Bank of Scotland, BNP Paribas (France) and UBS (Switzerland).

In the end, you may want to let the experts do the picking. But whether you hold financials through mutual funds, closed-ends or in individual-stock portfolios, own them. If the recession gets rougher and bankruptcies rise, stock prices could fall, but in the long run the sector is awfully appealing.
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