Will This Hated Sector Continue to Shine?

Spencer is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As 2012 winds down we would like to review some of the most hated financial stocks and determine which performed the best and which have the highest probability of flourishing in 2013.  The problem with the financial sector is that the media and federal regulations (think Volcker Rule, if it ever goes into effect) have made many financial firms appear to be the worst thing ever created, and this is making it difficult for banks to perform their daily operations.  With that said, we are expecting the financial sector to perform very well in 2013, just as in 2012, because many of these stocks were harshly beaten down from 2006-2009 and valuations are still low.  Also, we are seeing a turnaround on the financial side of the big banks that make us believe that they are slowly returning to full production.

2012 review... Sort of

The year may not be over, but for financial companies there are not many surprises left.  The biggest changes will be if a date is set for the Volcker Rule to go into effect or any action on the fiscal cliff “crisis” could cause bank stock prices to fall.  Nevertheless, the best performing major bank stock is Bank of America (NYSE: BAC), which is up 68% in 2012.  It must be noted that Bank of America was beaten down terribly over the past three years, thanks in part to the bank's acquisition of Countrywide and the government bailout.

Another top performing bank stock with negative sentiment is Citi (NYSE: C). Citi has rallied about 24% this year, compared to the Dow Jones Industrial Average’s 4.7%.  It should not be surprising that these two bank stocks are outperforming the market, considering that Bank of America and Citi fell off a cliff during the recession.  Bank of America lost about 94% of its value, while Citi lost about 98%.  The reason for the decline was not only because both firm’s earnings deteriorated, but also because many investors expected bankruptcy was inevitable.  And as we know, Citi and Bank of America received major bailouts in order to recoup some of their losses in the housing market.

Banks follow the fundamentals too

Throughout the recent recession many bank stocks took huge losses.  This can be blamed on homeowners not able to pay their mortgages, a lack of deposits due to skyrocketing unemployment, and thus a lack of interest income.   This caused investors and analysts alike to grow worried about the sustainability of large banks in general.  This worry has not subsided, but at least in 2012 we have seen growth and a turnaround across the board.  Citi, for example, has gone from a net loss of $27.7 billion in 2008 to a profit of $12-$12.5 billion in 2012 based upon our estimates for the fourth quarter.  This can be compared to a net profit of $11.1 billion in 2011.

Bank of America follows a similar pattern.  After taking a net loss of $2.2 billion in 2010, the bank will produce a profit of $5-$5.5 billion in 2012 compared to a profit of $1.4 billion in 2011.  This turnaround has helped the stock soar 86% over the last 12 months.  Keep in mind that Bank of America is still down about 80% since its pre-recession high.  Therefore long term investors that have held the stock for years are still down a considerable amount, but over the coming years we expect to see these losses continue to shrink.

This is important to note because it makes it clear that despite the negative sentiment surrounding these two banks, they are still following basic fundamentals.  Many Bank of America bulls tout that the stock’s book value is $20.40, which would indicate that the stock is selling at a massive discount to its value.  Similarly, Citi’s book value is $64.25, which makes the stock a terrific buy.  However due to new regulations such as the Volcker Rule and strict restrictions on mortgage applications it is understandable that investors are concerned about the future valuation of each stock.  Nevertheless, since major bank stocks continue to follow basic fundamentals we are expecting to see Bank of America and Citi continue to trend higher.

Looking for safety?

A stock such as Bank of America is a great stock for more risky investors.  While we believe the stock will continue its upward trajectory, we also expect to see severe short term volatility due to the fiscal cliff and Volcker Rule being pushed into 2013.  For risk-averse investors, the financial sector still has you covered.  The two best bets for safety are U.S. Bancorp (NYSE: USB) and JP Morgan (NYSE: JPM).  Not only have these stocks proven to be less volatile than Bank of America, they also provide dividends of 2.4% and 2.9%, respectively, compared to Bank of America's lousy 0.4% dividend.  Also, when compared to the other financial stocks JP Morgan and U.S. Bancorp have the least regulatory, financial, and business concerns.  These two safety stocks may not provide the highest returns but they will avoid catastrophic losses, assuming no more killer whales are spotted at JP Morgan.

sbeefyk1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , Facebook, JPMorgan Chase & Co., and Wells Fargo & Company and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook, Goldman Sachs Group, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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