QE3: Time to Buy Financials?

With QE3 now in play, we believe that several funds may be set to capitalize on the policy’s impact on financials. Fairholme and its founder Bruce Berkowitz believe there is much value to be found in the sector (see Bruce’s top picks), with his fund heavily weighted toward the U.S.’s biggest banks. Fairholme has kept over 75% over its 13F portfolio in financials for several years now. Berkowitz founded Fairholme in 1999 and has managed an annual return of 12.9% since the fund launched.

In addition to Berkowitz, we believe that several funds saw the wishy-washy economy earlier this year, and the heated talks of QE3 going into 2Q as a potential entry point into financials, believing that QE3 could serve as a solid tailwind toward price appreciation.

FAIRHOLME (FAIRX) Bruce Berkowitz

One of the biggest factors of QE3 will be Ben Bernanke and the Fed’s intent to keep the federal funds target range held between 0-0.25% until at least mid-2015. Lower interest rates are usually bad for financial institutions, given that NIM – net interest margin – is usually their primary revenue driver. There is no doubt that a continued tight NIM will put pressure on financial institutions’ bottom lines. However, the initiative by the Fed to stabilize the housing market should prove to be more of a positive for banks and their balance sheets.

American International Group, Inc. (NYSE:AIG), still partially owned by the U.S. Government, reported 2Q after-tax operating profit of $1.06 per share, versus $0.68 for the same quarter last year, and well above estimates of $0.57. Book value saw a modest increase at 4% to $56.07 per share, which is still well below the stock’s current share price of around $33.50. AIG continues to focus on paying back the U.S. Government, and recently reduced the U.S. Treasury’s stake below 50%. With a beta of 3.4, the volatility of this stock does present risks for investors despite its P/B ratio of 0.5, which is below the industry average of 0.8. Analysts are expecting current year EPS to come in much stronger than a year ago, with full year 2012 totals estimated to be $4.26, compared to 2011 EPS of $1.02.

In addition to Fairholme having over 40% of their 13F portfolio invested in AIG, there are ten firms we track that had over 5% of their 2Q 13F portfolios invested in AIG, with Silver Point Capital having 20%. John Griffin with Blue Ridge Capital took a new 10.4 million-share position during the second quarter, and AIG remains one of Diamondback Capital’s top picks.

Bank of America Corp (NYSE:BAC), another big portion of Fairholme’s 2Q 13F, at 12%, reported 2Q results that put operating earnings at $0.17 per share, down from $0.33 the same quarter last year and $0.31 from the previous quarter. Bank of America did manage to increase its Tier 1 common equity ratio to 11.24% for 2Q, up from 9.86% at the end of 2011. The company’s delinquency rates continue to be above its peers, but reserves now cover almost 2-times current annualized net-charge offs.

Bank of America has had positive insider activity during the first half of 2012. Fairholme has kept their Bank of America position for over a year and a half. Fairholme has some high-level fellow investors in Bank of America, including the likes of the gold bug John Paulson and Kerr Neilson of Platinum Asset Management. Ken Griffin upped his 1Q stake by 64% in 2Q, and D.E. Shaw upped his by 57%.

Citigroup Inc. (NYSE:C), like the previous two companies trades at a historically low P/B, currently at 0.5. The company’s 2Q operating results came in at $1.00 per share, versus $1.07 a year ago and $0.95 last quarter. Consensus estimates were $0.89. Citi remains troubled with core revenue generation, posting revenue that was down 7% year over year, versus expenses that were only down 2%.

JPMorgan Chase & Co. (NYSE:JPM) and Wells Fargo & Company (NYSE:WFC) have been two of the better performing financial stocks over the last five years, with JPMorgan down 13% and Wells only down 4%, while the other three names are all down over 80% over the five year period:  AIG down 98%, Citi down 93% and Bank of America down 82%. Both JPMorgan and Wells also have industry high P/B ratios, JPMorgan at 1.2 and Wells at 1.4.

Wells Fargo has attracted some of the biggest interest from the top funds we track.Warren Buffett has 18.5% of his 2Q 13F portfolio invested in Wells Fargo, and alongside him are Ken Fisher and D.E. Shaw, owning around 10 million shares each. Wells reported 2Q earnings of $0.82 per share, up from $0.76 the same quarter last year and $0.75 last quarter. The issues surrounding Wells’s shares are with valuation; the company trades at one of the higher P/B ratios and is expected to grow earnings 10% next year.

Insider sales for JPMorgan have been robust of late, possibly signaling that the stock is overdone for now. The company did report a pre-tax loss of $4.4 billion in 2Q related to the CIO issue, well above the May estimate of $2 billion, but below the market estimate of $5-7 billion. However, Jim Chanos upped his 1Q stake by 253%. The last three stocks mentioned – Citi, Wells & JPMorgan – are all top picks of Crispin Odey.

Jim Chanos was also upping his stake in Citi, by 266%, at the same time he upped his stake in JPMorgan.  As well, of the funds we track, there are fifteen with over 3% of their 2Q 13F portfolio invested in Citi.

The industry has not fully recovered from the financial crisis. The Dow Jones U.S. Financials Index is down almost 50% over the past five years, while the Dow Jones Index is only down 2%; the financials index is up 21% year to date, versus the Dow Jones up only 11%.

Two of the more beaten down names have been AIG and Bank of America. Both trade at P/B ratios of around 0.5, which is below the industry average of 0.8, but both also have a much tougher road back. Nonetheless, these two companies should benefit from QE3 with a stabilizing of their balance sheets going forward. However, for those looking for a less risky entry into financials, they should consider JPMorgan or Wells Fargo, each paying a decent dividend at 3% and 2.5%, respectively.

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