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This Conservative Stock Could Be This 'Hated' Sector's Best

Thursday, July 17, 2014 - 4:00pm

Nearly six years after the financial crisis, I think it's safe to say investors generally still don't trust the big investment banks, like Morgan Stanley (NYSE: MS), Goldman Sachs (NYSE: GS) and others.

Yet they're probably still the ones you hear and read about most, if only because they're the industry heavyweights and get the lion's share of media attention.

That's a shame. Because it likely causes many investors to overlook smaller rivals with equal or better investment potential but not the stigma the industry "leaders" still have for their major role in the near-collapse of the financial system.

One smaller rival has clearly been a far better investment, completely blowing away Goldman, Morgan Stanley, and the capital markets industry as a whole for many years now. During the past decade, this firm's stock has delivered annual total returns of 12.8%, compared with 7.3% for Goldman and a skimpy 1.9% for the industry. Anyone who owned Morgan Stanley during that time lost nearly 1% a year.

One distinguishing characteristic of this smaller rival is a thoroughly conservative approach to business -- the firm's calling card since its inception about five decades ago. According to management, the company is typically better capitalized than many competitors and currently has "excess capital and liquidity" it can use to support organic growth and niche acquisitions.

Importantly, the firm played essentially no role in the financial crisis, having had virtually no exposure to subprime mortgages in the years leading up to the crisis. And it refused TARP funds, even though it could have gotten a big fat government bailout.

So if you're in the market for a top financial stock that lacks the baggage you get with so many of the others, be sure not to overlook Raymond James Financial (NYSE: RJF).

The backbone of the company is its private client group, a national network of branded financial advisory practices serving 2.5 million clients with more than $400 billion of invested assets. This segment brings in 64% of Raymond James's annual revenue of $4.6 billion. There are also retail and investment banking, asset management, and other operations that together generate 36% of revenue and complement the private client group.

As always, Raymond James advises clients to eschew unnecessary risk, particularly with regard to fixed-income capital. Such capital should not be allocated to subprime mortgage-backed securities or other potentially hazardous fixed-income investments, the firm asserts (which makes sense since a key role of fixed income is to reduce investment risk). Raymond James instead tells clients who want to take some risk to do so with stocks using the portion of their capital allocated to equities.

While the firm typically relies on organic growth to increase sales and profits, it occasionally makes selective acquisitions of high-quality companies deemed compatible with the Raymond James culture. One of the latest was a $1.2 billion buyout of the well-regarded financial advisory firm Morgan Keegan in April 2012. At the time, the deal increased Raymond James's stable of advisors by about 1,200, to a total of nearly 6,700 -- roughly the number the firm has now.

Critics of the acquistion were worried about mass defections of Morgan Keegan advisors unhappy with the deal, but this never occurred. In the end, Raymond James managed a 90% retention rate.

The buyout has certainly been good for business, as revenue growth in the private client group has accelerated since the deal closed. In 2013, for instance, those revenues rose 18%, compared with about a 13% gain for 2012. In the first quarter of this year, the group's revenues climbed nearly 12%, up from a 9% increase in the first quarter of 2013.

Despite this success, management intends to stay choosy about acquisitions, rather than going on buying sprees like some competitors and wasting extra resources on difficult integrations that end up hurting margins. Indeed, the plan now is to pursue mainly organic growth in the private client group with a particular focus on the highly wealthy Northeast.

True, Raymond James has had difficulty gaining a foothold there before. However, in a recent article in OnWallStreet, a publication for advisors with high-net-worth clients, CEO Paul Reilly pointed out that the company has $1 billion in cash to spend on expansion and that it makes sense to leverage that capital in the Northeast.

Going forward, Reilly said, acquisitions (albeit smaller ones) will be more likely in business segments where the firm is underinvested, like asset management (such as mutual funds). Such "niche" acquisitions should augment this already briskly growing segment, which has increased annual revenues by 29% during the past couple of years, to about $293 million.

Raymond James' conservative business model has led to excellent operating margins, which have averaged 13.5% during the past three years, compared with the industry average of 4.8% in that time.

To help maximize margins, the firm has been shifting the private client group's advisor mix toward lower-compensated employees over contractors (who recieve higher payouts). Where possible, clients are referred to Raymond James's high-margin loan and banking services, although the company isn't known for a hard-sell approach to this activity.

Risks to Consider: Even though Raymond James had essentially no role in creating the financial crisis, its stock took a severe beating along with the rest of the financial sector. If things get really crazy again soon, expect the market to do the exact same thing to Raymond James regardless of its highly conservative business model.

Action to Take --> At about $50 a share, shares of Raymond James trade for less than 14 times next year's estimated earnings per share (EPS) of $3.57, making them an attractive buy. Because of factors like a strong financial position, the successful Morgan Keenan acquisition, and an ambitious yet prudent business plan, the firm is a good bet to meet consensus projections for average annual EPS growth of 17% for the next five years. This gives the stock just over 100% upside to $103 out to mid-2019. If there's a correction or another crash and RJF tanks with the rest of the market, consider adding to your position.

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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