News Analysis date published New: 
Friday, July 27, 2012 - 08:30
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Friday, July 27, 2012 - 10:16
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Friday, July 27, 2012 - 08:30

This Hated Sector Could See Major Gains

Friday, July 27, 2012 8:30 AM

More than one-third of companies in the S&P 500 have released 2012 quarterly results, and a clear set of themes have emerged. Profits have been slightly better than expected, while revenue has been a tad disappointing. More important, the forward view has been fairly dim: A wide range of companies have tamped down expectations for the second half of 2012.

Still, it always pays to take a close look at the numbers to identify any emerging pockets of sector strength. This way, investors can make more educated investment decisions and adjust their portfolio accordingly. Each earnings season, I take an early look (focusing on mid-cap and large-cap stocks) and then take a later look (focusing on small-caps) to see what kind of companies are exceeding profit expectations.

To find the earnings winners, I screen for companies that have topped earnings-per-share consensus forecasts by at least 25% (and at least five cents more than the consensus forecast). For this particular screen, I am only looking at companies worth at least $1 billion in market value.

Here are a dozen companies that have delivered solid second-quarter results -- relative to the consensus estimates.



Yet, there are other half-dozen stocks that meet the same criteria, with another kicker. These stocks sport very low price-to-earnings (P/E) multiples.

Notably, every one of these companies toils in the very same sector -- banking. In light of the troubled economy, the fact that these banks keep delivering solid quarterly results is quite impressive. These banks are capable of robust profit growth when the economy mends, and their shares are quite cheap right now.

(In case you're wondering, my favorite bank stock, Citigroup (NYSE: C), didn't even make this list, because the bank managed to exceed profit forecasts by "only" 12%).

These stocks may look inexpensive, based on their 2013 P/E ratios noted in this table, but they''re even cheaper than that -- assuming the second-quarter outperformance leads analysts to raise their forecasts.

The further out you go, the brighter the outlook for these bank stocks. That's because the slow economy has affected the profit margins in their various businesses, but as the economy improves -- led by a housing rebound and rising consumer lending in general -- these banks should be able to benefit from a combination of rising revenue and profit margins. Very broadly speaking, these banks could see earnings per share rise 20% in 2014 and again in 2015.

Of course, these bank stocks remain in purgatory for a pair of reasons.

First, the European crisis lends a high degree of uncertainty about global banking system's stability. These banks are better-positioned to handle any curve balls from Europe than was the case in 2008. Moreover, their European exposure is largely hedged away. In fact, you could argue that major U.S. banks stand to take global market share from hard-pressed European rivals in coming years. Still, as long as the European clouds remain in place, any bank rally may be muted.

The second factor: regulation. Legislators continue to tinker with the final details of tighter bank regulation under the rubric of Dodd-Frank Act. It's increasingly clear banks will be operating in a more constrained regulatory environment in the years to come, though it's clear this will result in only moderate pressure on profit margins.

In fact, many of these changes will force these banks to reduce risk, which argues for an expansion in their multiples. Once the cement hardens on all of the regulatory changes, investors will be able to better quantify the banking sector's long-term margin profiles. And it will again be "safe" to buy bank stocks.

Risks to Consider: One of the key headwinds for these banks stocks is that they could fall lower before any long-term rebound -- if European policy makers, or are elected leaders in Washington decide to spook investors anew with their posturing and inaction.

Action to Take --> Virtually every sector had headwinds in place right now, from retail to technology to industrials to agriculture. Bank stocks are no exception, but they are notably cheaper than most other stocks, now sport stronger balance sheets, and have as much leverage to an improving economy as any other sector. It's hard to know if you'll make money in bank stocks this year. But the stars are aligned for ample upside if you've got a multi-year time horizon.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of C in one or more of its “real money” portfolios.