Bank stocks to go long onAugust 21, 2012: 5:00 AM ET
If you look beyond recent mishaps and scandals, there are values to be found in financial shares.
By Russell Pearlman, contributor
FORTUNE -- Disaster and misbehavior have dominated recent headlines about big banks. Whether it's multibillion-dollar trading losses (J.P. Morgan Chase), a settlement for rigging interest rates (Barclays), a Senate report asserting money laundering for drug cartels (HSBC), or assorted bad press for Standard Chartered, Capital One, Wells Fargo, and others, some financial giants seem bent on returning their reputations to the darkest lows of 2008. Little surprise, then, that the KBW index of bank stocks has slipped 7.3% since April, while the broader market has been flat.
It's not just the news. Investors fear that Dodd-Frank reforms, which require holding more capital and limit certain trading, will squeeze profits. Meanwhile, many banks are still taking losses on pre-crash mortgages, and interest rates are near historic lows. Yes, that means banks can get away with paying 0.05% on a savings account. It also means they can't lend money at high rates.
As investors flee, a few intrepid souls are buying. Value investor Bill Nygren, manager of the Oakmark Fund, now has 23% of his $6.2 billion portfolio in financial stocks, according to fund research firm Morningstar. He already had a stake, but bought more as bank shares faltered in recent months. Some share prices, he says, are "assuming that the worst recession since the Great Depression will happen every five years or so." For example, Nygren thinks J.P. Morgan's (JPM) annual profits could jump 50% by 2014 as interest rates eventually rise and the mortgage mess recedes. Even if that doesn't happen, JPM's stock is trading for nine times its last 12 months of profits. If the bank achieves its expected earnings of $5.23 a share next year and returns to its five-year average price/earnings ratio of 15, the stock price would double, to $75.
Like JPM, other banks with headaches have gotten stronger. Wells Fargo (WFC) (which agreed to pay $175 million in July to settle a federal fair-lending case, but denied wrongdoing) scooped up Wachovia during the financial crisis and has demonstrated "strong performance in a weak market," as Morningstar's Jim Sinegal put it in a recent note. He praised Wells' fundamentals, such as attracting deposits and making loans. With a P/E of 11, it's less of a bargain than JPM, but boasts a higher return on equity and little exposure to the mess in Europe, says Jim Kee, president of South Texas Money Management, which oversees $2 billion and recently bought Wells shares.
Capital One Financial (COF) (which in July agreed to a $210 million settlement for deceptive marketing of credit-protection products) bought ING's U.S. online bank and HSBC's (HBC) credit card unit. Capital One has a P/E of 9, a bargain given its expected $6 in earnings per share this year and the fact that its credit card revenue continues to climb even as Americans charge less.
The next year may be dicey for banks, says portfolio manager Adam Scheiner of RBC Global Asset. But much of the recent bad news won't be harmful (or remembered) over the long run, analysts contend. The worst effects of the housing bust are slowly ebbing, and interest rates will climb at some point, making loans more profitable. Long term, Scheiner says, there's a compelling case for big banks.
This story is from the September 3, 2012 issue of Fortune.