IDEAL Opportunities in Unloved Financials

10/28/2015 10:00 am EST

Focus: FINANCIALS

James Pearce

Director of Research, Investing Daily

Jim Pearce, senior editor of Personal Finance, looks to the out-of-favor financial sector, highlighting a trio of favorites, an insurance firm, a credit card play, and a leading bank.

Steven Halpern:  Joining us today is Jim Pearce, senior editor of Investing Daily Personal Finance, one of the industry's longest running and most widely read financial newsletters.  How are you doing today, Jim?

Jim Pearce :  I’m doing great, Steve.  How are you?

Steven Halpern:  Very good.  Thanks for taking the time.  Today we’re going to talk about the banking industry, an area where you happen to have spent the first half of your career.  Could you tell us a little about the changes you’ve seen over the past few decades in the industry and how that impacts the future?

Jim Pearce:  Sure. I started out as a stock broker in 1983, and at that time, you had a lot of community banks and you had a lot of small regional banks which...you really didn’t have the large national banks like you have now, but that’s all from the same decade that PCs really took off.  

Information technology enabled the massive economies of scale, particularly in the operations side of banking, which is where their single biggest cost area is. For example, in 1988 I was working for a regional bank here in Virginia—or headquartered out of Virginia—called Sovereign Bank.  

In 1991, it merged with the bank called C&S out of Georgia.  The very next year that entity merged with NCNB Bank out of Charlotte, North Carolina to become what is now Bank of America and that’s the pattern that occurred with several other banks.  

You have Wells Fargo now as a huge national bank and US Bank. What’s left is kind of this barbell kind of clustering of banks.  You have the big mega banks on one end of the spectrum and with very little regional banks in the middle and then a cluster of very small community banks at the other end.  Basically, we’ve gone from having a lot of medium size banks to either huge banks or little banks, but with very little in between.

Steven Halpern:  Now, since the financial meltdown, bank stocks have significantly underperformed the overall market.  What’s responsible for this underperformance and do you expect that to continue?

Jim Pearce:  I do not expect it to continue because I think the single biggest cause was the money flooding the market from quantitative easing. Affected a couple of things. One is it pushed down interest rates to the point that banks could not maintain the historical margins.  

Back when I started out in the 1980s, there was kind of this running joke that most people in the banking industry operated by what was known as the three-five-three rule which was that you pay 3% interest on your deposits, you charge people 5% interest on their loans, so you can make it to the country club by 3:00 for your tee time.  

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That really was how it was.  Now, of course, when you can only pay...I don’t know about you, but my checking account pays virtually, literall,y almost nothing in interest.  CDs might pay as high as 1%.  

Loans...the last mortgage I took out earlier this year was less than 4%.  There’s just very little room for banks to squeeze out margin, which has also forced this consolidation in terms of finding ways to generate more revenue.  Now the quantitative easing is over and the Fed is talking about raising rates.  

Those spreads should expand some and the banks should be able to increase their margins.  At the same time, that’s also less money flooding the stock market that was going into momentum stocks and banking stocks are not momentum stocks.  

That money is going...you know, we saw massive increases in a lot of tech stocks and other industries that are more scalable, but the end of quantitative easing has done two things.  It’s going to decrease the amount of money flooding the stock market and it’s going to allow interest rates to gradually rise so that banks margins improve.

Steven Halpern:  So, in addition to your personal analysis which suggests that the financial sector could see better times ahead, you also utilize a proprietary stock rating system called IDEAL and that system also suggests that the financial area is undervalued.  Could you give us an explanation of the Ideal system and what is says about the banking area?

Jim Pearce: Sure, I’d be happy to. I introduced IDEAL to our subscribers a year ago because I anticipated that quantitative easing would resolve and what is often referred to as a two-tier market where you have winners and losers—and roughly an equal number of winners and losers—so that the overall change in the stock market is relatively minor and that’s exactly what we’ve seen this year.  

Stock markets have been up or down, plus or minus 5%, or so, from where it started the year, but with very little net change; however, in the top half you have stocks that have outperformed the market substantially and in the lower half you have stocks that have done very poorly, so I created IDEAL as a screening tool to help me identify those stocks that would end up in the winners category. There are three metrics that I use in IDEAL.  

The first one is dividend yield because I think investors going forward are going to demand more of a current return on their investment then waiting years and years for a growth stock that may not pan out.  

The second one is changing that operating cash flow because that’s the fuel the companies are going to need to grow.  In the past, again with quantitative easing flooding so much money in the market, they can borrow it very cheaply and go out and acquire other companies or other assets.  

Going forward, they’re going to need to be able to generate more of that cash flow organically, so I measure the change, the net operating cash flow, and then the third thing is relative evaluation based on the forward P/E ratio.

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In other words, I’m looking for stocks that are paying a good dividend, are growing their cash flow, and, oh, by the way, are trading at a discount through the overall market and that’s what I use as my screening tool.  

Then I take a look at each one of those companies to determine what’s going on specifically with each one of them.  In some cases they are value traps and you want to avoid them.  In other cases there’s some real value there.

Steven Halpern:  So turning to some individual stocks, it shows there are few that you consider to be buying opportunities among the unloved financials and one of those is ACE Limited (ACE), a global insurance firm.  What’s the story here?

Jim Pearce:  Well, the story may not look very exciting on the surface, I mean, it is an insurance company, it is huge.  This is not the kind of stock that’s going to become a so-called 10-bagger.  

On the other hand, it is the kind of stock that for years to come will be able to churn out increasing profits, increase their dividend every year, you know, they acquired Chubb earlier this year—which is another huge insurance company—and they did it in a way that it will be immediately accretive to the earnings.  

Unlike some acquisitions, it sometimes set a company back for a year or more, they’ll be able to essentially start booking some of that revenue all the way down to the bottom line and yet it only trades in a forward P/E ratio of twelve and a half times next year’s earnings while paying a dividend of 2.5%.

So this one I consider to be more of just a core holding for a conservative investor who wants steady gains in a stock that’s not dependent on momentum or anything like that.

Steven Halpern:  Now, another out-of-favor idea in the financial area is the credit card company, Discovery Financial Services (DFS).  What are your thoughts here?

Jim Pearce:  Well, honestly, I think they’re one of the best marketers in the business.  Over the past three years they’ve been able to grow their total credit card balances by 5% annually when total growth for the industry is only 0.1%.  In other words, it’s flat, yet they’ve grown it at a very healthy clip.  

At the same time, they’ve been able to reduce their allowance for charge-offs, well, it’s essentially a third less than the industry average, so they’re just clearly dong it better than their competitors.  

Now, at the same time, they also operate a virtual bank that offers traditional bank deposit products, which they haven’t really put a lot of muscle into while interest rates have been so low, but once the Fed starts raising rates, they can also start competing with the brick-and-mortar banks on things like CDs, checking accounts with healthier margins.  

Again, it’s only trading at a forward P/E at a little under 10 and pays a forward dividend yield of 2%, so I think this one is going to sneak up on people.  

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It’s got some opportunity to really leverage its assets in a way that isn’t immediately visible and that’s one of the things my IDEAL system is trying to do, is just sort of identify some of these companies before it becomes apparent to everyone else.

Steven Halpern:  Finally, let’s turn to a company you mentioned earlier, Wells Fargo (WFC), one of the largest players in the banking market.  What’s the attraction with Wells Fargo?

Jim Pearce:   Honestly, I just think they execute a little better than anybody else in the banking industry.  They’ve had 8% deposit growth, lower than industry norm charge-offs, and they reduced their average cost of deposits by 35% over the past two years.  Here in the banking business, those are all of the metrics that essentially directly contribute to profit ability.  

They also have one of the bigger and one profitable wealth management divisions of any of the large banks and I think that’s also going to be more important than a lot of people realize, because the baby boomer generation is now retiring at the rate of something like 10,000 people a day every day for the next ten years.  

When baby boomers are working they’re savers, they’re more growth oriented, and they’re a little more risk tolerant, but when they retire they become spenders, they want investments that are less risky, and a lot of them are not going to feel comfortable self-directing very large accounts, you know their 401(k)s and that sort of thing.  

Companies like Wells Fargo are there specifically to serve the baby boomer generation, so that’s going to be an added kicker to profitability, but here’s a company again trading at 12 times forward earnings and paying a dividend yield of just under 3%.  

All three of these stocks are just very solid core portfolio holdings.  They’re not the kind of stocks that are going to double overnight, but they’re not the kind of stocks that are going to fall out of the bed either.  We saw what happened yesterday with Valeant Pharmaceutical, kind of the poster child of momentum stocks, a well-known hedge fund, wrote a disparaging article about them, and the stock has dropped something like 40% over the last 36 hours.  

That’s the problem with momentum stocks in this market. Investors now are comparing one stock to another and they’re not comparing it to some theoretical idea of what they think the stock might be worth three or four years from now.  

In this kind of market, stocks that are paying the current yield can growth their net operating cash flow and are priced fairly are the ones that are going to end up getting more and more investor capital and all three of these stocks will do that.

Steven Halpern:  Again, our guest is Jim Pearce of Personal Finance.  Thank you so much for your time, today.

Jim Pearce:  Your welcome, Steve.  Thank you.

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