My Top Contrarian Play Offers Big Income Potential
As we kicked off the fourth-quarter earnings season this week, one sector got rocked on disappointing results.
The market knew that earnings would be weak for banks, but it looks like investors were underestimating just how bad they’d be.
Citigroup (NYSE: C) reported an unbelievable 86% drop in profits to $0.06 per share, missing analyst estimates by 40% and sending the stock tumbling for a 12% loss for the year.
Citigroup isn’t alone. JP Morgan Chase (NYSE: JPM) and Bank of America (NYSE: BAC) both reported results that sent their shares lower. The Financial Select Sector SPDR ETF (NYSE: XLF) fell as much as 4% this week, partly in anticipation of what the market knew would be a tough month.
But is there a silver lining to weak earnings? And are there other catalysts that may send bank shares higher from here?
Betting on the Forest Despite the Trees
Lower profits from trading activities were a major culprit for the earnings disappointments. Implementation of the Volker Rule meant that banks could no longer bet their own money in proprietary trading, a lucrative business in previous years. Further, high volatility in December kept many investors from taking positions. Bond trading revenue at Bank of America, for example, dropped a stunning 21% in Q4.
Looking over earnings releases and economic conditions, I get a sense that the market is missing the proverbial forest for the trees. A fixation on the weakness in trading profits is hiding some strong support for the rest of the year and could mean profits for investors willing to look at the big picture.
Beyond trading, other revenue sources are doing well. At JPMorgan, investment banking revenue rose 11% to a record $557 million. And its debt underwriting fees jumped 31% as cheap interest rates and lots of corporate cash drove merger-and-acquisition activity. Lower interest rates also spurred a 15.5% increase in commercial and industrial lending and 16% growth in credit card loans at Wells Fargo (NYSE: WFC).
The legal fallout from the financial crisis seems to finally be winding down as well. Legal expenses reported by Bank of America fell to $393 million in the fourth quarter, well off the $5.6 billion booked in the previous quarter.
The biggest upside catalyst for the banks this year is probably the simplest of all, the economy. Consumer confidence increased last week to its highest point in almost seven years as the national average for gasoline prices neared $2 a gallon. While lower oil prices have hit the energy sector, they could boost the overall economy. The World Bank upgraded its forecast for U.S. economic growth to 3.2% from a previous estimate of 3% in June.
Banking guru Dick Bove is optimistic on banks for just that reason, saying, “If the economy does well, it will be almost impossible for the banks not to do well.”
WFC: Attractively Priced Bank With Less Risk
Among the banking stocks, my favorite is actually one of the cheapest and one of the most protected against weak trading revenue. Shares of Wells Fargo trade for 12.7 times trailing earnings versus an industry average of 14. The bank is the nation’s largest mortgage lender and books just 2% of its fee generation from trading activities.
Mortgage lending at Wells Fargo fell 12% to $44 billion in the fourth quarter from the same period last year. However, it could get a big boost in the first quarter from lower interest rates. Rates on a 30-year fixed mortgage have dropped to 3.81% from a high near 4.4% in the third quarter, making prospective homeowners more likely to take the plunge.
Shares of Wells Fargo have fallen 5.8% so far this year, getting caught up in weak investor sentiment but outperforming most other major banks. We can use a put selling strategy to generate income while we wait for a rebound.
By selling a put option on this stock, we are agreeing to buy 100 shares per contract at the option’s strike price if shares are below that price when the option expires. For accepting the obligation, we are paid a premium, which lowers our cost basis. If shares are above the strike price at expiration, that premium is ours to keep free and clear.
With shares trading for $51.64 at the time of this writing, we can sell the WFC Feb 52.50 Puts for a limit price of $1.85 a share ($185 per contract).
If WFC closes below the $52.50 strike price at expiration on Feb. 20, we will be assigned shares at that price. Since we received $1.85 in options premium, our actual cost is $50.65 per share, a 2% discount to the current price.
There is always the possibility that we will have to buy the shares, so we want to make sure we have enough money in our account to cover the purchase. This means setting aside $5,065 for every put contract we sell, plus the $185 we collected from selling the puts.
If the share price closes above $52.50 on expiration, we keep the premium for a gain of 3.7% in just 33 days. If we were able to make a similar trade every 33 days, we would generate a 40% annual rate of return.
There are still risks to banking stocks as new regulations come to bear, but the bigger picture is positive, and I like Wells Fargo in particular for its focus on lending. Investors can book a quick profit through a put selling strategy or have the chance to hold the shares for a longer-term recovery.
If we do get assigned shares, some investors will no doubt simply hold the position for capital gains. But for those of you looking to maximize your income, there is another option.
You can “rent” out your shares to other investors, collecting monthly income from your position just like you would if you owned a rental property. Traders who use this strategy can earn an extra 9%-plus monthly on the stocks they own.
If you want to learn more about this simple strategy, we’ve prepared a free research report that gives you all the details. Click here to access it.