Two sleeper financial stocks: Bank of America and Tower Group

Author: Andy Schornack

Covestor model: Financial Services

The performance for this model during the month of December was reassuring as it outperformed both the SPSY (S&P 500 Financials Index) and the S&P 500 Index. There were no changes in the portfolio during the month of December.

2011 was a particularly tough year for the financial services sector. The S&P 500 Financials (SPSY) benchmark significantly underperformed the S&P 500 index in 2011. My model outperformed the SPSY index but unfortunately underperformed the S&P 500 index for 2011.

Looking forward, I am very positive about the portfolio’s construction. The top five positions are currently New York Community Bancorp (NYB), Morgan Stanley (MS), KKR & Co (KKR), Cincinnati Financial (CINF), and JP Morgan (JPM). I’ve discussed all of these in some depth in my recent writeups. All five provide for a nice yield and strong prospects for returns over the coming months.

The “sleepers” in the portfolio that I think are worth mentioning are Bank of America (BAC) and Tower Group (TWGP).

BAC sold off excessively in 2011. The bank has continued to be battered by headline risk more than any other financial institution in the country. Though there are risks still embedded in the Countrywide subsidiary, the bank has taken very specific action steps to reduce non-earning assets and non-core investments to build capital ratios and simplify the business.

In 2011, it shed stakes in Blackrock, China Construction Bank, and reduced its international credit card portfolio. All actions have been positive to the capital of the bank by either reducing risk weighted assets or resulting in gain on sales. The lawsuits and challenges remaining will be time consuming and costly to defend; however, I am of the position that the built in option in the stock price has provided more than enough cushion to cover any future losses. At closing on January 9, 2012, the stock is trading at $6.27 equating to a market cap of $63.55 billion. The tangible book value as of September 30, 2011 was $134 billion. (Source)

The $71.45 billion discount appears excessive to me, based on continued earnings, prior reserves, and ultimate long-term earnings power of BAC. It is a small position in the portfolio, and given the uncertainty I have not added further to the position. That said, I think the risk-reward on a small position at these levels continues to look attractive.

TWGP had some setbacks this past year due to natural weather disasters this past summer and a more operationally related setback on the integration of the OneBeacon acquisition. The company, $20.60 at close on January 9, 2012, is trading at a discount to book value, $25.42 as of September 30, 2011. The analysts are on average estimating earnings of $2.86 in 2012 and the stock pays a $0.1875 dividend quarterly (3.60% indicative yield Jan 9, 2012). I like the management, its strategy, and its historical performance. This is one stock I am considering increasing the model’s position in during 2012, as property and casualty insurance rates should move positively after the natural disasters in 2011.

I believe 2012 will be another year of slow growth on the macro front, but there continues to be value in carefully selecting and positioning a portfolio of individual equities that are trading at discounts to intrinsic value.

Financial institutions have been continually picked apart by the media. However, there remains significant value in the regional bank sector. NYB, Renasant Corporation (RNST) and F.N.B. Corporation (FNB), to name a few in the portfolio, do not have exposure to Europe and are looking to grow through loan growth, new branches, and/or acquisitions. All three provide stable historical dividend returns to their investors and have proven to be well managed financial institutions.