Too Big to Fail, or too Good to Pass Up?

By Jason Hall - March 6, 2013 | Tickers: AIG, BAC, C, JPM, WFC | 0 Comments

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Bank of America (NYSE: BAC). American International Group (NYSE: AIG). Citigroup (NYSE: C). Just the names alone are cringe-inducing for a lot of us. 

After all, with the help of ratings agencies Moody’s and McGraw-Hill's Standard & Poor's, these companies combined to not only nearly cripple the American economy, but destroy billions of dollars in shareholder wealth at the same time. And when one considers that much of that wealth was in mutual funds and pensions, and not just the portfolios of the "One Percent," it's another reminder that the foreclosure crisis hit Main Street in more ways than one:

BAC Market Cap data by YCharts

While it's not quite a trillion dollars, and yes, I have cherry-picked the dates, the combined market cap for the five companies above was reduced by a mind-boggling $776+ billion from the market peak on October 11, 2007, to the bottom on March 9, 2009.  And while it's not likely that anyone actually bought in at the market peak, and got out at the very bottom, the devastation was real.  There are many people that will never recover that lost wealth. 

Thanks for salting the wound, pal; and we've heard all of this before

Fair enough. I'm not really telling you anything new. But it's important to see the chart above, because it puts better context on this one:

BAC data by YCharts

Even through the heart of the Great Recession, Wells Fargo (NYSE: WFC) and JPMorgan Chase (NYSE: JPM) managed to come through with share prices essentially flat from the market peak in 2007.  However, share dilution hides the fact that both of these companies have increased their market cap by 56% and 20% respectively, since the peak. 

On the flip-side, AIG investors were wiped out to a large extent, and that horse is out of the barn.  Similarly, Bank of America and Citigroup investors are unlikely to recover much of their losses for years.  With that said, the collateral damage caused by, to paraphrase Warren Buffett, the "weapons of mass financial destruction" that were the Moody's and Standard & Poor's-approved mortgage-backed securities, created a great opportunity to get in on some great turnaround stories that are probably safer than many other "safe" bets, and easily a better bet than bonds that guarantee a loss against inflation. 

Get tomorrow's Dividend Aristocrats today?

Bank of America, Citigroup and AIG, are vastly reduced compared to what they were five years ago.  And while that's not typically the description that investors want to hear when looking for an investment, it's exactly what makes these three companies worth taking a closer look at.  The bottom line is that often, the best deals are found at the bottom of the scrap heap, and it's important to remember that sometimes things end up on the scrap heap simply because they look like junk.  Remember, the market is usually late to the party, and many of the larger Mutual funds and pension funds that fled these companies in recent years, won't get back in until and unless dividend are at much higher levels.  And as Amanda Alix reported recently, both BofA and Citi could be on the verge of increasing their dividends:

"Indeed, for both Bank of America and Citi, some analysts do feel that some capital return may be in order. Analysts at JPMorgan think B of A may be able to raise its dividend to $0.04 from the current $0.01, and Citi's divvy might increase to $0.20. Both banks may possibly be allowed to buy back approximately $4 billion in stock, as well."

And with both banks paying only 0.4% and 0.1% today, any increase in the payout would be well-received.  However, with the profit-engines at both of these banks still stalled, there's little guarantee that even if these increases happen, we will see the payouts return to historic averages. 

AIG is in a similar situation, with CEO Bob Benmosche having stated numerous times that he would like to reinstate a dividend sometime in 2013.  And with the Fed having liquidated it's entire holding in AIG (at a profit, it's worth noting,) and the company seemingly completely turned around, the opportunity to buy looks good. 

JPMorgan Chase and Wells Fargo both pay a dividend today in the low-2% range.  And while this is nice, it's still well below the historical averages for both of these companies of over 3%.  And while there is certainly less upside with these two banks for investors, there's also a better, predictable stream of income that is more likely to increase in coming years than the paltry payouts of BofA and JPMorgan Chase.  Again, from Amanda Alix (parenthesis mine):

"For instance, RBS Capital Markets has categorized the 18 banks undergoing the Fed testing by capital distribution, and these two institutions (BofA and Citigroup) are in the bottom tier, with expected payout levels of only 10% to 30% of earnings. By comparison, the middle level, which includes Wells Fargo, is likely to be able to return capital at rates of between 50% and 75%, and those at the top of the heap -- JPMorgan and Goldman -- will be allowed payouts of 75% to 100% of earnings."

Simply put, bank regulators are going to let JPMorgan and Wells Fargo give more back to investors than BofA or Citi, simply because they're more likely to be able to do so, while not requiring future government bailouts in the face of another crisis.

But any way you slice it, a 2% dividend in a couple of years, on a share price that could be 2-3 times today's price, could be a powerful way to long-term capital growth, and that's the upside opportunity to taking a long position. 

So what should I buy?

It depends, like always, on how much risk you can stomach.  And while my honest opinion is that the perceived risk is much higher than the real risk at this point, there are never any guarantees with investing.  Let's take a quick look at price-to tangible book value, or PTBV: 

While PTBV is a good measure to help in valuing these companies, it's also important to note that both Wells and JPMorgan have traditionally traded at a higher multiple (3-5) than either BofA or Citi (2.5-4.)  Additionally, AIG, as an insurer and not a bank, would be more in line with its multiple near 2, historically speaking.  

Needless to say, the dogs of this group are trading a very low multiples to their PTBV.  And while the upside is there, seeing these companies return to their historical averages will only be a product of business execution.

With that said, I think that the biggest risk is lost time if BofA, Citi, or AIG stagnate in their efforts to turn around completely, while Wells and JPMorgan just don't offer the same upside potential. 

Foolish bottom line 

Like most things in life and all things investing, diversity pays off.  The banking sector should continue to strengthen on the rebounding housing market, and AIG has almost completely turned the page.  Taking a risk on BofA or Citi, and tying it to an investment in Wells or JPMorgan can mitigate the downside, and provides more upside at the same time.  My personal picks are Wells, AIG, and Bank of America, and I intend to not just hold, but add to my positions in all three for the foreseeable future. 

But your situation may be different.  Get out there and figure out what makes sense of your portfolio. 

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