Author: Andy Schornack
Covestor model: Financial Services
Disclosure: Long RNST, TAXI, FMER, NYB, MS, JPM, GS
The financial services sector continues to bear much of the concern in the global markets. This is a result of the growing fear over sovereign debt exposure to European Union countries. The performance in the portfolio for September continued to be disappointing. The portfolio outperformed the SPSY (S&P Financials Index) and underperformed the S&P 500 Index.
It is my opinion that the market continues to overreact on the sovereign debt issues within US based financial institutions. Contagion has certainly concerned many investors and has punished even financial institutions without any direct ties to Europe on the fear of a Euro failure.
Several of the regional banks in the portfolio have limited ties to Europe and likely would not see any significant impact other than the resulting economic slowdown from a macroeconomic level. Some of the positions in the portfolio that I believe are most sheltered are: Renasant Corp (RNST), Medallion Financial Corp (TAXI), FirstMerit Corp (FMER), and New York Community Bancorp Inc (NYB). They performed well in comparison to many other financial institutions during 2008-2010 and I don’t see any reason for concern given existing valuations and balance sheet structures. All four also pay handsome indicative dividends to shareholders: 5.34%, 7.74%, 5.63%, and 8.4%, respectively as of close of trading on September 30, 2011. (Source: Yahoo Finance)
The four positions with the largest European exposure are JP Morgan (JPM), Goldman Sachs (GS), Bank of America (BAC), and Morgan Stanley (MS) – in no particular order. I am comfortable with my position sizes in all four banks. The challenge in Europe has and will continue to create volatility in the financial sector. However, I believe these four are adept at working through the current marketplace and will reward shareholders in the long-term.
As I have continued to increase the portfolio’s position in MS, I wanted to again touch on it specifically. In the past month, there have been bloggers and others referring to the 10-K filing for year end 2010 indicating MS’s cross border outstanding to French Banks totaling $39,009 million. The material point that has not been clarified and should be clarified by management on the upcoming Q3 conference call is the collateral securing the cross-border outstandings. The number above is a gross figure and as noted in the 10-K it doesn’t include a reduction for related securities collateral held. This is an extremely important point and I look forward to further clarification. I have continued to add to the position, most recently at $12.25 on October 4, 2011 which is a fraction of the June 30, 2011 tangible book value of $26.61. Based on my analysis, management has taken appropriate steps since 2008 which has provided it with one of the strongest capital ratios in the industry, a stronger balance sheet, reduced risk, and ultimately will better position the company for long-term profits.
One change that was made at the end of the month was the sale of American Capital Agency (AGNC). This was a mortgage REIT that was first purchased for the model in February 2010. As I mentioned in my investment report for March 2010 recapping February’s activities, “My investment in [AGNC] was based on the viewpoint that the economy remains weak, the resulting yield curve spreads will continue to be steep to normal over the upcoming 12 months.” Bernanke and the Fed recently implemented Operation Twist and the strategy to flatten the yield curve. Operation Twist made this investment less attractive and more risky. It was sold and the funds redeployed into NYB and MS.
The volatility can be stomach wrenching, but I have structured this model to also provide dividend income. The target yield is a minimum of 3%. The indicative yield of the portfolio is currently exceeding the minimum yield as of September 30, 2011.*
Overall, my position since last month has not changed. I think this is an excellent time to invest in the financial sector given widespread skepticism and concern on events in Europe, where the U.S. impact is not quantifiable. This provides uncertainty to the masses and opportunity to the diligent. From a fundamental level, net interest margins will be tightened over the balance of 2011 and 2012, but I fully anticipate towards the end of 2012 to see positive improvements in margins. This coupled with continued improvements in credit quality and banks augmenting their revenue channels through increasing fee income will provide great upside potential for the financial sector over the next three to five years.
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* Note: Indicative yield is calculated the last known dividend, divided by the current price, and is shown annualized. It is therefore sensitive to price movements and does not represent a promise of income or total return over the next 12 months.
