Financials Count on a Solid 2014

 | Jan 16, 2014 | 10:30 AM EST
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This is financial earnings week. We've heard from names like Wells Fargo (WFC) and Bank of America (BAC) and both results have been quite good.

Despite a drop in revenues, Wells Fargo continues to benefit from its positioning coming out of the financial crisis. With the Wachovia acquisition and other shrewd moves, Wells has become the largest supplier of mortgages in the country. As interest rates climb, allowing Wells to charge more for loans without an equal increase in deposit rates, the net interest margin will increase. Even a modest 25-50 basis expansion the NIM translates into real dollars against an expanding loan base.

Bank of America continues to prove my thesis that the bank is improving and simplifying its business. A favorable earnings report sent shares up 2%, with the stock now trading near $18 -- up from $5 three years ago. Wrapping up this week, we will hear from names like Goldman Sachs (GS), JP Morgan (JPM), and American Express (AXP).

Despite the advance in share price over the past several years -- most financials are up 100% or more in the past two to three years -- these industry behemoths still represent solid bets in 2014. Mr. Market, although starting to give banks their due, still remains cautious on financials in the future. Indeed, the era of 15% to 20% return on equity levels from financials may be a thing of the past, at least for the foreseeable future. The new normal now is closer to 10% to 15% thanks to regulatory guardrails put in place post 2008 and 2009.

Low interest rates, however, mean the "raw material" that banks need to produce its products – money -- is dirt cheap. By low interest, I'm not referring to only zero percent interest rates. Even if rates show modest advances over the next couple of years -- a condition the Federal Reserve indicated it would support -- banks will pay little to hold money.

That will lead to continued improved margins and growing profits. Those profits will translate into increasing dividends as well as share buybacks. If you assume that a bank's stock price will follow the return on equity -- a fair assumption over the long run -- the annual return on major financials could exceed 12% to 15% annual when dividends and share buybacks are added into the mix.

 Given that names like Wells Fargo, BofA, JP Morgan, Citigroup (C) and Goldman Sachs all trade between 10 to 13x forward earnings, the valuation remains at a significant discount to the overall S&P. Yet as a group, the financial industry is likely to generate better earnings growth than the S&P as a whole. Those factors should represent out performance for patient investors.

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