This is the first in a three-part series on sector opportunities as seen by a contrarian value investor — Senior Portfolio Manager Kevin Holt.
In the wake of the Great Recession, and significant regulatory changes, investors are concerned that large banks may not be able to generate the type of profits that they have in the past. We don’t disagree with that assessment. However, we do disagree with the current equity valuations of the large banks — we believe the market has priced in a too-pessimistic view of profitability.
Take Citigroup for example (3.94% of Invesco Comstock Fund as of March 31, 2014.) Altogether, the company generates about a 6% return on equity. However, its segregated Citi Holdings assets (primarily low-quality mortgage paper) are scheduled to migrate off the books over the next five to seven years. That leaves a core banking operation that produces a 13% return on equity. Historically, a bank with a 13% return on equity would trade somewhere around 1.3x tangible book value. Since March 31, 2014, Citigroup had been trading in a range between $47 to just under $49, or around 0.85x tangible book value.
At the same time, we calculate that Citigroup will generate $50 to $60 billion in excess capital over the next three years, and we expect most of that will be returned to shareholders through dividends and buybacks. That’s a significant sum for a company with a current market cap of less than $150 billion.
As a deep value manager, I’m looking for companies that are trading at a significant discount to their true value, and I’m willing to wait patiently for these companies’ share prices to catch up to our view. Citigroup is typical of what we own: Its near future is relatively unexciting, but it’s trading at 50% of what we believe it can be worth in the next three to five years.
Overall, we believe the quality of the financials sector is the best we’ve seen in at least a decade. However, we see this story playing out over the course of the next four or five years. For long-term value investors, we believe one of our chief advantages is our patient, long-term approach.
Return on equity is the amount of net income returned as a percentage of shareholders equity.
Invesco Comstock Fund’s investment objective is total return through growth of capital and current income.
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