Saturday, October 17, 2015

Financial Stocks: And a Megabank Shall Lead Them (XLF)

We've been droning on about the market's need for the financials to perform for a month now and, despite a head fake or two, for the last couple weeks they actually have.
Here's the ETF for the financial stocks in the S&P 500:
XLF  The Financial Select Sector SPDR Fund daily Stock Chart
As an example of one that intrigues, riskier-than-peers Citigroup has the potential to triple if it can get above long term resistance around 63 bucks:
C Citigroup Inc. monthly Stock Chart
Been down so long it looks like up to me, eh what?

Another part of the sector that shows promise are the property/casualty insurers, most of whom are up since we posted that Hurricane Joaquin would probably not make landfall back on Oct. 1.
This group is a bit trickier as the U.S. has not seen a landfalling hurricane in a decade (Sandy was an extra-tropical storm when it hit NY/NJ) and the prospect of a La Niña next year raises the potential for storms but higher interest rates would do wonders for their earnings.

Unfortunately there is no ETF for the group. The writer of the Barron's piece does mention ACE Ltd.which last July announced it will buy  East Coast focused Chubb for $28.3 bil. but which is already up around 5% since the hurricane decided to head to Europe (and whose remnants caused storms in Poland).

And on and on, we'll probably have a few thousand words on this stuff by year end.
C $52.69 at the close Friday, XLF $23.55, ACE $108.95.

From Barron's:
Investor Chris Davis’ Financial Stock Picks
The Davis Advisors head sees opportunities in Wells Fargo, JPMorgan Chase and insurer Markel.
Seven years after the collapse of Lehman Brothers tipped off a global financial crisis, investors are still leery of financial stocks, which as a group have yet to fully recover. “Whenever there is uncertainty, investors’ knee-jerk reaction is to sell financials,” says Chris Davis, chairman of Davis Advisors. 

Yet, he thinks the opportunities in financials are as compelling today as they were in 1991, when he launched the $830 million Davis Financial fund (ticker: RPFGX). Despite record profitability, improving market share, and the prospect of higher interest rates, he says, high-quality financials are trading at significant discounts, relative to their historical levels. “Many of the companies we own not only survived the financial crisis, they have actually grown,” says Davis.

Of course, Davis has long had an affinity for financials. His grandfather, Shelby Cullom Davis, made a name for himself, and a fortune, investing in banks and insurers, beginning in the 1940s. In 1969, Davis’s father, also named Shelby, founded an advisory firm based on these principles and launched what is now the $14.3 billion Davis New York Venture fund (NYVTX). While the fund, which Chris Davis co-manages, is diversified across all sectors, more than a third of its assets are invested in—you guessed it—financial services.

In 2007, Davis took himself off the Davis Financial fund’s management team to focus on running the firm’s larger strategies. The hiatus ended in 2013, when he retook the helm and asked Ken Feinberg, his partner of 15 years, to step down after several years of significant underperformance on both funds. Davis promptly pared the fund’s nonfinancial holdings. It ended 2014 up 13% for the year, and has bested 64% of its peers and the broader market so far this year. 

Davis, 50, recently spoke with Barron’s about why the diverse and misunderstood financial sector still holds long-term promise. 

Barron's : Where are financials in their recovery?
Davis: It’s important to start by saying that financials aren’t just a single group. They are lumped together, and yet they have huge differences in business models. Some have credit risk, some have interest-rate risk, some have real- estate exposure, some have consumer or capital-market exposure, some are domestic and some are global, and so on.

That said, I look at the period of the early ’90s, when I launched the Davis Financial fund, and think we’re in a very similar environment now. We’re through the crisis. The companies are well off their lows. There are fewer competitors. The models have been proven. The management teams have been proven. Yet nobody much likes them. The result is that they’re trading at as wide a discount to the S&P as they’ve traded at in the past 20 or 30 years. 

Will they ever get the multiples they deserve?
What’s wonderful is that they don’t need to. In a way, their destiny is in their hands. They’ve generally built capital to where it needs to be from a regulatory point of view; they are, on average, generating between 7% and 9% of their market cap per year in distributable cash. If multiples don’t grow, then what you’re going to see is steep increases in dividends over the next five years and a reduction in the shares outstanding.
Meanwhile, the companies we own are generating terrific earnings today even with low interest rates, but sooner or later, if and when interest rates go up, their earnings will go up sharply.
Have you ever had doubts about the sector? 
Actually, the time that was the most unsettling was 2006, 2007, and 2008 because our relative performance had fallen. We were getting beaten by these home finance funds or leveraged financial funds. The further you went out on the risk curve, the more leverage you had, the better you did. 

An analogy that my grandfather used to use was: “If you’re building a ship to sail across the ocean, build it very light and, if the weather’s good, you will win the race. But if the weather’s bad, you won’t survive the race.” It’s about finding that balance. 

Even though all the stocks did lousy after the financial crisis, it was clear that the high-quality companies would survive. In the case of Wells Fargo [WFC], instead of a run on the bank, there was a run to the bank. Depositors were lined up to put their money in.

What do you look for in a financial company?
A defining characteristic of most financial companies is that culture is an advantage. Yet it doesn’t show up in a financial statement. There was very little difference in the business model of Wells Fargo and Bank of America [BAC] for 10 years. Same geographies, roughly the same products, roughly the same returns. Yet you go through the financial crisis, and one is down 60% or 70%, and the other one has record profits a few years later. The difference is culture. 

What do you mean by culture?
In a financial company of any kind, your earnings are based on a huge number of estimates, from what percentage of your loans will go bad to what percentage of your premiums will pay off. The most dramatic example is in insurance. Say you have an event that you think will occur once every 100 years, but you price it as if it will occur once every 200 years. You’re going to look good for a long time, in all likelihood, but eventually that will take the company down. 

By accounting choices, reserve practices, past credit losses, and disclosure practices, you can build a pretty good mosaic about the culture of an organization. When you look through our portfolio, it’s companies like Wells Fargo and JPMorgan Chase [JPM] that have that culture.

JPMorgan has had its share of controversy. Why do you like it?
If I had to boil it down, I would say it’s a company that is generating 8% to 9% of its market cap per year in distributable cash, and [CEO] Jamie Dimon may be the greatest financial executive of my time. He has been characterized as deeply hated and mistrusted, and yet he has behaved with transparency, integrity, and relentless focus....MUCH MORE
We started sniffing around in March:
"Big Banks Announce Plans To Return More Cash To Shareholders" (XLF)
And got serious in September:
The One Market Sector That Really Matters Right Now (XLF)
Once Upon a Time: The Bear Market Fiction
Headlines That Comfort When Long
Friday's Action: Biotechs Blow Up
Headlines You Don't Want If Long: "Bank stocks rocked by weak jobs data"n (XLF; BKK)
Equities Through The Looking Glass
As I was posting yesterday's "Headlines You Don't Want If Long: "Bank stocks rocked by weak jobs data"n (XLF; BKK)" I was thinking "But aren't weak jobs reports what we all want?"

Corey at Afraid to Trade captured the new reality with his first line in "Oct 2 Bad Jobs Report Bull Market Update and Stock Scan":

The Jobs Report was worse than expected so let’s buy stocks because the Fed won’t raise rates!!!
All I had was "I'm guessing there won't be a rate hike this year."
The Dow Joneses had a 459 point reversal from the bottom, closing 4/10 point off the daily high.