February 05, 2004, 8:58 a.m.
Banking on Financial Stocks
If they’re so good, why are they so cheap?

Year in and year out, financial stocks make remarkably stable and productive investments. In fact, it's kind of a mystery. If they're so good, why are they so consistently cheap?

Here's just one example. John Hancock Regional Bank Fund (FRBFX) — the largest, but by no means best-performing financial-stock mutual fund — has returned an annual average of 14 percent over the past 10 years, beating the benchmark Standard & Poor's 500-stock index by a solid three percentage points with risk levels that are well below average. Over the past five years, while the market was dead flat, the Hancock fund, which owns such stalwarts as Wells Fargo (WFC), rose 46 percent. It has done well through thick and thin.

According to the Value Line Investment Survey, diversified financial services firms have done 50 times better than the market as a whole since 1967. Conventional large banks have done 6 times better — which is still pretty good.

You don't get returns like these unless companies both increase their profits swiftly and, for some reason, go largely unappreciated for the accomplishment.

A friend of mine, the former chief executive of a bank and a skillful investor, says that most Wall Street analysts simply don't understand the accounting practices of banks — not to mention those of the more specialized lending institutions that have sprung up lately. But we shouldn't be too hard on the analysts. Banks are black boxes. Their earnings can swing widely from quarter to quarter on their reserves and write-offs for bad loans, figures that are largely discretionary and difficult to predict because loan portfolios are confidential.

This extra short-term risk may be the reason that banks tend to trade at low valuations. Consider Citigroup (C), the world's largest financial-services company. On Jan. 20, it announced that earnings for the fourth quarter of 2003 had doubled, to $4.8 billion, the third-largest profit ever earned by a U.S. company. Citigroup, which has 200 million customer accounts in 100 countries, also raised its quarterly dividend to 40 cents, up from 20 cents a year ago. The stock now yields 3.3 percent — more than a five-year Treasury note. The consensus projection is that Citigroup profit will rise at an average of 12 percent for the next five years.

The stock, however, trades at a measly price-to-earnings (P/E) ratio of 14, compared with a P/E of 30 for the stocks of the S&P 500.

Another example of apparent value is MBNA Corp. (KRB), the leading issuer of affinity credit cards (marketed with the endorsement of well-known institutions, such as the Toronto Blue Jays and National Geographic). It has consistently produced returns on equity of more than 20 percent annually and has increased its earnings in a Beautiful Line from 18 cents to $1.79 per share over the past decade. Yet it trades at a P/E of 15 and has a dividend yield of 1.7 percent.

Similarly, H&R Block (HRB), which, in addition to its tax-preparation business, owns a mortgage company and an accounting firm, carries a P/E of 16 despite a solid dividend, earnings that have risen each year since 1995 and expected profit growth of about 13 percent annually. No wonder super-investor Warren Buffett bought 9 percent of the stock for Berkshire Hathaway Inc. (BRK).

Of course, some financials do get into trouble and flame out spectacularly. For instance, in 2001, shares of Providian Financial (PVN), a consumer lender, went from $64 to $2. Between early 2002 and early 2003, shares of Metris Cos. (MXT), a credit-card issuer, dropped from $25 to $1.25.

Overall, however, this is a wonderful industry to own. Banks earned about $300 billion last year, a third of all corporate profits. Vast brainpower is being devoted to engineering new financial products, and the process of consolidation — that is, companies in the sector buying one another — continues. But excelling at picking financials is an art and a science that few of us amateurs can master. That's why, last month, I visited the ultimate professional, the master: Tom Brown.

Brown runs Second Curve Partners, a New York-based hedge fund — that is, a portfolio owned by institutional investors and wealthy individuals — that concentrates on financial stocks. Last year, Second Curve returned 72 percent, compared with 30 percent for the broad financial sector. On the day I visited, Jan. 22, Brown was already up 21 percent for 2004.

Between 1989 and 1997, Brown was named the number-one regional-bank analyst in the country eight times by Institutional Investor magazine. He was tough and outspoken, and he earned the enmity of bankers whose stocks he didn't like — such as Edward Crutchfield of First Union, who barred him from headquarters in Charlotte, N.C., and called him a "little red-haired boy."

The next year, Brown was summarily fired from Donaldson, Lufkin & Jenrette when DLJ brought in a new team of investment bankers, who, according to Brown, "felt my views, particularly those critical of many of the acquisitions announced recently by some large banking companies, would not be good for their business."

Brown's sudden departure, wrote the Wall Street Journal, "raises the question of what happens when it is feared that an analyst, no matter how sharp his skills at stockpicking or guiding money managers, won't play ball with the investment bankers who are soliciting underwriting deals ... from the same companies he covers." Sound familiar?

Brown went on to Julian Robertson's Tiger Fund, then launched Second Curve, which since its inception on May 29, 2000, has doubled its investors' money — compared with an increase of 20 percent for the S&P Financial index and a loss of 22 percent for the S&P 500.

Nervous investors need not apply. Second Curve is concentrated in a small number of stocks (his top holding can comprise 25 percent of the fund's value) and uses leverage, or borrowing. Brown also sells a few stocks short — that is, bets they will go down. The portfolio is "designed to lead to superior investment performance," says Brown, "but with above-average short-term volatility." In other words, while financials as a sector tend to provide a fairly smooth ride, Brown offers something wilder — but, so far, more profitable.

When he really likes a company, Brown will load up on its stock, buying more if it goes down. And he will keep holding it until the market recognizes its value. In his presentation to investors last month, he quoted Buffett, who in turn paraphrased economist John Maynard Keynes: "Don't try to figure out what the market is doing. Figure out a business you understand, and concentrate."

Right now, what Tom Brown understands and concentrates on is Capital One Financial (COF). Again, he quotes Buffett: "Great investment opportunities [come] around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised." That's the case, Brown believes, with Capital One, which took a huge dive in 2002 after problems with regulators. (Let me hasten to add here that I have owned shares of Capital One since last June.) Capital One, based in Falls Church, is among the largest issuers of MasterCard and Visa credit cards, and it also moves swiftly in and out of other parts of the lending market, such as auto loans. Brown points out that the company put a major effort into selling credit cards to college students; then, when competitors entered the market, it pulled out.

"Scientific testing is the spinal cord of the company," says Brown, who adds that management uses conservative policies to recognize income and build loss reserves. It's "one of America's great companies," he says, increasing its earnings by 31 percent annually over the past five years and anticipating growth of 15 percent or more over the next five. Yet shares trade at a P/E of only 14. Yahoo Financial estimates that Capital One's PEG ratio — that is, its P/E divided by its expected five-year growth rate — is just 0.89. A figure under 1.00 generally indicates a bargain.

What else does Second Curve own?

Three companies that fall into a category Brown calls "recoveries and transformations" — Providian, Metris, and AmeriCredit (ACF), a "sub-prime" auto lender. All three of these stocks suffered big collapses in the 2001 recession and its aftermath, but they've been recovering this year. Metris, Brown says, trades at $5.78 a share, while its book value (that is, net worth on the balance sheet) is about $9.50.

Then, there are "great companies at reasonable value," such as Southwest Bancorp of Texas (OKSB) and Commerce Bancorp (CBH), based in New Jersey. Both are fast-growing regional banks with hard-driving chief executives. Southwest, which has increased its earnings at a 15 percent rate over the past five years, trades at a P/E of 14. Commerce has grown at a 30 percent rate and, according to Brown's calculations, carries a PEG ratio of just 0.46. Commerce stresses service in an industry not known for it. "Our operating model," says Commerce Chairman and President Vernon W. Hill II, "plays into the weaknesses of our competitors, which [provide] lousy service [for] their customers."

A final category is "reinventors and misunderstood" companies, a group that includes E-Loan (EELN), an online provider of mortgages and other loans, and Portfolio Recovery Associates (PRAA), "a great little company that just came public." E-Loan fell to nothingness in the tech crash but has since become profitable; the stock, however, still trades below $3, at a P/E of just 7. Portfolio Recovery buys bad credit-card debt at a penny or two on the dollar and tries to get the debtors to pay up.

Even if you don't have the many hundreds of thousands of dollars on hand to invest in Second Curve, you can follow Brown's investing views on his fascinating website, www.bankstocks.com. Brown also uses the site for gathering intelligence through posted messages from employees and suppliers of the companies he covers.

If you're searching for a Brownesque manager of a public fund in the financial sector with a superb track record, look at Nicholas Adams, who runs First Financial Fund (FF), a closed-end fund that trades on the New York Stock Exchange. Over the past 10 years, the fund, which I first brought to the attention of readers in 1996, has returned an annual average of 19 percent, beating the S&P by seven percentage points. But, like Brown, Adams takes his investors on a wild ride. Over a 12-month stretch in 1998 and 1999, the fund lost half its value.

Adams has a more diversified portfolio than Brown, and he also looks for bargains, especially among small-caps. His latest list of holdings is headed by Countrywide Financial (CFC), a large-cap mortgage lender with a P/E of 6 and a PEG ratio of 0.54, and Hudson City Bancorp (HCBK), a New Jersey savings bank. Adams also owns Southwest Bancorp.

A more conventional sector fund is Fidelity Select Financial Services (FIDSX), which carries a four-star rating from Morningstar Mutual Funds and has returned an annual average of 15 percent over the past 10 years. Top holdings include Citigroup, insurer American International Group (AIG), and Bank of New York (BK). The fund, which no longer requires a load, or upfront fee, has a relatively decent expense ratio of 1.1 percent. First Financial charges expenses of 1.3 percent.

A final fund worth consideration is a relative newcomer, Emerald Banking and Finance (HSSCX), with five stars from Morningstar and an average annual return over the past three years of 23 percent. Emerald focuses on small-cap banks such as Allegiant Bankcorp (ALLE), based in St. Louis, and Northrim BanCorp (NRIM) of Alaska. Unfortunately, Emerald carries a lofty expense ratio and a 1 percent load. Maybe you get what you pay for.

Certainly, you seem to get more than what you pay for with well-chosen financials. But beware. As Tom Brown says in his latest newsletter for partners: "The banking business is morphing at an astonishing rate these days." And Tom Brown's partners, at least so far, are making an astonishing amount of money.

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com . Of the stocks mentioned in this article, he owns Capital One, MBNA, and First Financial. This article originally appeared in the Washington Post.

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