Climbing A Wall of Worry

July 3rd, 2014
in contributors, syndication

Investing Daily Article of the Week

by Brian O'Connell, Investing Daily

Stock investors track the U.S. economy tightly, like a barnacle on the hull of a boat. And these days, that tracking mindset is sliding underwater.

Follow up:

Michael Mussio, CFA and Managing Director with FBB Capital partners, says that the U.S. economy is growing, but at a glacial pace. Mussio says

We’re continuing a ‘slow and low’ recovery – as evidenced by yesterday’s low GDP figure. In that regard, the stock market continues to climb a wall of worry, and the more investors fear the markets rise, the healthier it actually is. The expected rise of the Fed’s rates, Europe’s deflationary environment and increased political turmoil from Russia to Iraq — are all known concerns for the market.”

Consumers are pulling back on their spending, and that’s another concern for stock market investors. Both spending and consumer confidence fell in April, “unexpectedly” as the media likes to put it these days. In addition, gross domestic product cratered to -2.9 percent in the first quarter of 2014, the worst quarterly GDP showing since 2009, in the teeth of the Great Recession.

On top of that, St. Louis Federal Reserve Chairman James Bullard came out this week with a surprisingly candid prediction that the Fed would hike interest rates in the first quarter of 2015, ahead of most expectations on the rate-change front.

Not all Wall Street observers agree that the move will help things along, economically. Max Rudolph, founder of Rudolph Financial Consulting, notes

The rate hike will impact the economy by slowing it down. There was just a significant revision down for Q1 GDP growth, and with QE reducing further the economy will continue to slow. We are susceptible to a shock (e.g., energy, conflict) as well."

So what’s an anxious trader to do in such a tepid economic environment? In short, look for value and ride out the weak recovery for another year or so.

That’s where mid-sized banks can boost portfolio earnings. The good ones have solid balance sheets, are making money on loans (especially in a sweet spot in the U.S. Midwest, where housing has recovered ahead of other U.S. sectors), and have largely escaped the regulatory scrutiny facing megabanks after the passage of the Dodd-Frank financial reform bill four years ago.

Three banks I especially like right now are KeyCorp (NYSE: KEY), U.S. Bancorp (NYSE: USB), and Royal Bank of Canada (NYSE: RY). Let’s examine them, one at a time:

KeyCorp – KEY is trading at $14.00 per share, as of June 26, offering some solid upside for value-minded investors. It also has a very strong dividend payout of $1.80 – a perk that traditionally allows value investors to sleep better at night during soft economic periods, like the one we’re facing right now.

In addition, earnings growth is up this year at a faster pace than any year since 2010, and the stocks price-to-earnings ratio is relatively low, compared to most banks stocks these days.

The bank’s mortgage portfolio alone is likely worth a “buy” on the stock. Housing prices in the Midwest are growing at a rate ahead of the rest of the nation, and KEY is already harvesting profits on an old-fashioned banking product – the boring, but financially sturdy 30-year fixed-rate mortgage loan.

U.S. Bancorp – The other mid-range bank stock I really like, U.S. Bancorp, also has a good dividend story to tell. The bank just hiked its quarterly common stock dividend by 6.5 percent to 24.5 cents per share – it’s the fourth dividend uptick since 2011. The move domes on the heels of a decision by management to green light a $2.3 billion share repurchase program, through early 2015.

In the first quarter of 2014, USB sent 67 percent of its earnings to shareholders, via its stock buyback and dividend programs. The moves signify a healthy banking company that believes in returning capital back to shareholders, while solidifying its balance sheet at the same time.

Royal Bank of Canada – Go up north for another good value financial play with Royal Bank of Canada. The stock is trading at $70 per share, but it has the potential to go much higher – to over $80 per share.

It has one of the best dividend rates in the banking sector, at 3.80 percent, and has plenty of room for upside growth. Of all the primary Canadian bank stocks, RY holds the lowest growth rate over the last 12 months, at 28 percent.

But its solid track record in two key, profitable banking markets right now – wealth management and capital markets – give it a big upside over banking competitors who target the significantly less profitable retail banking side of the market. With revenue growth strong, and a good return on equity, Royal Bank is another bellwether banking stock in a weak economic growth climate.

Despite weak economic growth, and the disturbingly bad Q1 GDP number, there is value to be had out of this market. Find it first in the banking sector, with the three stocks listed above.

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