Why We're Chasing Banks, but Not One in Particular

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

During the past year, and particularly in the past several months, the performance of large US banks has been strong. As Valuentum members are aware, we were anticipating this expected outperformance when we added exposure to the banking sector in January 2012 .

<img src="/media/images/user_12958/xlf_large.jpg" />

Shares of Citi (NYSE: C), Bank of America (NYSE: BAC), JP Morgan, Goldman Sachs, and Wells Fargo (NYSE: WFC) have all rallied at least 5% during the past month, and the banking cohort continues to work toward raising cash returns to shareholders via buybacks and dividends. Goldman Sachs continues to register a 9 on our Valuentum Buying Index.

Though net interest margins, a key profit metric for banking institutions, have experienced pressure from the low interest rate environment, stronger liquidity and improved loan loss reserves have put several of the formerly troubled firms in much better shape.

Bank of America, in particular, has been impaired by legal malaise and massive uncertainty regarding its Countrywide Mortgage business. Yesterday, it reached a $10.3 billion settlement with Fannie Mae to settle repurchase claims on a whopping $1.4 trillion in unpaid mortgages. The case will cost Bank of America $3.6 billion in cash payments to Fannie Mae, and it will also cost the company $6.75 billion to repurchase some residential mortgage loans that it values at a lower price. The move is an incremental positive, in our view, as it provides more clarity about the firm’s future legal obligations.

Citigroup has also been on a roll lately after reporting strong third-quarter earnings, but more importantly, after former CEO Vikram Pandit was ousted and replaced by current CEO Michael Corbat. Corbat announced some management changes earlier this week, and we think it’s clear the market believes Corbat is the right man for the job. We think cost cutting and earnings expansion could be the story for Citi during 2013.

The higher-quality banks, including US Bancorp, JP Morgan, Wells Fargo, and to a lesser extent, Goldman Sachs, also appear poised to see strong results in 2013. Before Jack Lew was nominated, Rumors persisted that JP Morgan’s CEO Jamie Dimon could leave to replace departing Treasury Secretary Tim Geithner. But even if he had left, Dimon is known for keeping a deep bench, and he’s positioned the company favorably, despite the “London Whale” scandal.

Wells Fargo continues to be the largest mortgage originator in the US, and is well-positioned to benefit from additional housing market strength. Goldman Sachs may not be the premier banking institution in the US anymore, but the company will benefit tremendously from increased capital markets activity. A strong equity market could lead to a strong M&A and IPO market, while we could see firms rush to issue debt before borrowing costs begin to rise.

Nevertheless, we simply don’t view investing in individual banks as a sound investment strategy. It’s easy to forget that, just a few years ago, a few bad years and billions in bad bets eliminated every dollar of earnings these banks ever generated. The tail risk (to the upside and the downside) is simply too high, in our view.

Although we at Valuentum aren’t interested in purchasing a single financial institution, given the leverage inherent in the banking system, we think it’s prudent to allocate a position to a diversified financial sector ETF in the portfolio of our Best Ideas Newsletter. We’re big fans of the Financial Sector Select SPDR ETF (NYSEMKT: XLF), which is up over 26% since we added it to the portfolio last January.

The banks are in much better shape than in year’s past, but we won’t forget the lessons of the past. We continue to think diversified exposure to the banking sector is the best risk-adjusted approach.

Valuentum holds the XLF in the portfolio of its Best Ideas Newsletter. The Motley Fool recommends Wells Fargo & Company. The Motley Fool owns shares of Bank of America, Citigroup Inc , 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!

blog comments powered by Disqus