2 Strong Financial Stocks to Buy for Long-Term Growth

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Fannie Mae and Freddie Mac issued new rules which are aimed at reviving mortgage lending and the housing market. These rules are thought to be important since it's mandatory for banks to buyback troubled mortgages. The Federal Housing Finance Agency will apply these changes to future loans beginning in 2013. Existing loans will be unaffected.

Edward J. DeMarco said that “Lenders want more certainty about their risk exposure, and the enterprises want to ensure the quality of the loans.”

Fannie Mae and Freddie Mac has made their audit processes more stringent, it is also reviewing files of loans defaulted during the housing bubble, i.e. 2005 to 2009, for bad underwriting. During the current financial year it forced banks to buy troubled mortgages worth $18.9 billion. It is still working closely with lenders to resolve old claims prior to September 2008.

Leading banks like JPMorgan Chase (NYSE: JPM), Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC), and Ally Financial (ALLY) made provisions of $3 billion in their books during the first 6 months of 2012 to buyback troubled home loans.

Fannie Mae was the subject of controversy when reports stated that it paid more than $500 million to Bank of America for the transfer servicing of 384,000 mortgages. Bank of America later denied this. Fannie Mae defended these transfers because they were made to reduce portfolio losses which were forecast at $10.9 billion. It was hoped that a specialty servicer like Bank of America could help it reduce losses by $1.7 billion to $2.7 billion.

 

A bipartisan group of congressmen including Democrat Maxine Waters and Republican Darrell Issa asked for the audit to ensure that the transactions were valid and tax payer money was not misused. The audit found that Fannie Mae paid higher amounts than were owed to servicers, presumably to make the transaction fast and avoid scrutiny. Clearly this strategy backfired.

 

Banks without Lending

 

The United States is currently in a deleveraging super-cycle, has an aging population which has less future income to borrow against, and is now adding more regulatory requirements for lenders. This does not bode well for residential mortgage lending as we know it.

 

Without the origination of new loans, big banks in the United States are zombie banks. This means that investors should only buy banks if they are trading at a discount to their book values. It also means that investors should demand significant discounts to other financial services companies which derive income outside of lending.

 

Financial Stock Valuations


In this environment banks like Bank of America should be cheap. Investors could find value in BAC by buying shares around their current $9 per share price tag. It's cheap even after a 59.4% jump in price over the past year. Its most compelling valuation multiple is its 0.4 price-to-book multiple, which is much cheaper than the 2.05 S&P 500 average. In addition, Bank of America shares are valued at a compelling 9.6 price-to-earnings ratio, a value which is significantly lower than the 14.1 average of the S&P 500. The firm's 1.57 price-to-sales ratio is in line with today's prevailing market multiples and do not disconfirm that it is cheap.

 

JPMorgan Chase is not as deep a value at roughly $41 per share. The shareholders of this large cap bank stock have benefited from a 24.4% jump in price, even as news of a trading scandal came to light. Yes, JPMorgan shares are valued at a compelling 9.37 price-to-earnings ratio, a value which is significantly lower than the 14.1 average of the S&P 500. However, the stock trades at a 0.8 price-to-book multiple, twice that of Bank of America.  Investors can buy more revenues per dollar from the S&P 500 since this index has a price-to-sales ratio of 1.29 while this stock has a much higher 2.61 ratio.

 

JPMorgan shares offer a dividend yield of 2.96% dividend which is much higher than the yield of the 10-year treasury bond. Future dividend payments are likely because the company pays out 26% of earnings as dividends, so earnings could drop considerably before dividends must be cut. This may be a plus for income investors, but ultimately it is not as good a bet as Bank of America.

Wells Fargo stock is too expensive at a price of roughly $35 which seems impossible to justify when compared to its peers. Investors can buy more revenues per dollar from the S&P 500 since this index has a price-to-sales ratio of 1.29 while this stock has a much higher 3.71 ratio. Wells Fargo shares are trading at an attractive 11.4 price-to-earnings ratio and a 1.23 price-to-book multiple. Both of these metrics are richer than those offered by Bank of America.

 

Like JPMorgan Chase, Wells Fargo may be attractive to income investors. Its shares offer a dividend yield of 2.55% dividend which is much higher than the yield of the 10-year treasury bond. Future dividend payments are likely because the company pays out 0.22 of earnings as dividends, so earnings could drop considerably before dividends must be cut. However, this does not make up for the valuation disparity between Wells Fargo and Bank of America.

 

Investors should accept higher valuation from transaction and payment processing companies which offer better growth prospects.

 

For example, American Express (NYSE: AXP) is trading at $57 per share. The firm's 1.94 price-to-sales ratio is in line with today's prevailing market multiples. American Express shares are trading at a fair 13.35 price-to-earnings ratio, in line with the S&P 500 average. The 3.36 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio.  Since the firm has a bright future beyond the value of its existing assets, the price-to-book ratio does not detract from the cheapness of its continuing operations. At this price, American Express offers growth at a reasonable price.

 

Not all stocks in the transactions space should be purchased. Mastercard's (NYSE: MA) stock is too expensive at a price of roughly $452, a price level which seems impossible to justify. Equity in this this company is rich on a price-to-sales basis since shares trade at a 7.91 multiple, much higher than the 1.29 the S&P 500  average. Mastercard shares are trading at a rich 27.0 price-to-earnings ratio, almost twice the 14.1 average of the S&P 500 index. The 9 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio.

Similarly, Visa (V) stock at roughly $134 is too expensive to be a prudent investment. Equity in this this company is rich on a price-to-sales basis since shares trade at a 10.81 multiple, substantially higher than the 1.29 the S&P 500  average. Visa shares are trading at an indefensibly high 133 price-to-earnings ratio. The 4.16 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio.

 

 

Conclusion

Investors should pick bank stocks based on discounted existing assets, while picking transaction companies for growth at reasonable value. Bank of America and American Express are financial services companies that investors should consider.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., MasterCard, and Wells Fargo & Company and has the following options: short OCT 2012 $55.00 puts on American Express Company, short OCT 2012 $60.00 calls on American Express Company, long OCT 2012 $65.00 calls on American Express Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend American Express Company and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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