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  1. Home
  2. / Investing
  3. / Financial Services

Financials Lead the Way in 2012

The ride may be bumpy, but exposure to much-maligned financials could provide a tidy payoff.
By SHAM GAD Dec 27, 2011 | 03:00 PM EST
Stocks quotes in this article: BAC, GS, GS, C, STI, JEF, RF, MS, JPM, WFC

According to the cliché, what rises too much will fall, and what has fallen will rise again. Looking ahead to 2012, financials will rise among the fallen -- and the reasons are anything but cliché.

Financials will likely outperform the broader market in the year ahead because rarely has an industry been so hated and loathed over the past couple of years. That sentiment has led to a price-to-value distortion that exceeds any level of rationality. Specifically, both Bank of America (BAC) and Goldman Sachs (GS) offer the most attractive opportunities, although Citigroup (C), as well as relatively smaller players like SunTrust Banks (STI), Jefferies Group (TICKER) and Regions Financial (RF), will do well in the year ahead.

The reality is that the financial crisis in Europe is affecting the valuation of the U.S. financial industry beyond the hit that any balance sheet would take, even if 100% of any European exposure was written down to zero. Moreover, concerns about exposure to Europe may be exaggerated. In November, ratings agency Fitch released a report outlining the gross exposure the U.S. big six -- BAC, C, GS, Morgan Stanley (MS), and JPMorgan Chase (JPM) and Wells Fargo (WFC) -- have to stressed European markets, referring to the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

Bank of America, the redheaded stepchild of the financial industry, has about $14.5 billion in gross exposure, or 11% of its Tier 1 capital. Trading around $5.60 a share Tuesday, BofA could be one of 2012's big winners even if the market environment remains similar to what it is now. BofA at $5.60 is a reflection of Mr. Market's frustrated with the stock, therefore keeping shares depressed in response to the uncertainty. Not even the brightest analysts can fully grasp BofA. But $5.60 is an inefficient stock price because if you think BofA is dead, then you shouldn't own it at any price. If BofA stands to exist, then its true value is much higher.

By 2014, CEO Brian Moynihan plans to reduce expenses by $5 billion, or nearly 10% of today's market cap. In other words, if BofA's core earnings were more than $10 billion in 2010, those cost reductions represent a 50% boost to the bottom line. Since the third quarter 2010, BofA reduced riskier assets by $117 billion. In 2009, BofA cut risks tied to European debt by more than 40%. Regarding the bank's major issue, litigation uncertainty, investors will come to realize that they are overestimating BofA's ultimate liability. The last thing the federal government is going do to, especially in an election year, is levy damages that jeopardize the recovery of nation's largest consumer bank.

As for the much-vilified Goldman Sachs, the facts speak for themselves. In 2011, Goldman ranked as the top advisor in global takeovers and equity offerings. As much as the headlines have bashed Goldman, the company's customers continue to bring it business. The importance of Goldman's investment banking business cannot be stressed enough: Clients who use Goldman for investment banking services are likely to give Goldman other business. That's more important than ever today since the biggest cloud over Goldman is the impact of the Volcker Rule on the company's trading business, which accounts for over 60% of Goldman's revenue. But with net margins over 40%, the advisory business is very lucrative.

Next year is likely to see the cloud of uncertainty posed by regulatory actions clear a bit. Europe will have to make painful decisions, but in the end, the market will react favorably as one layer of uncertainty is removed. Asset write-downs are likely to continue improving, which will improve the bottom line. Most important to note, prices have become so out of whack with value that investment capital is likely to shift from overvalued sectors to undervalued ones. The ride may be bumpy, but by this time next year, prudent exposure to financials could provide investors with a tidy payoff.

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At the time of publication, Gad was long BAC and GS, although positions may change at any time.

TAGS: Investing | U.S. Equity | Financial Services

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