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Banks seem to be the companies that everyone loves to hate these days. Many politicians and journalists are still bashing the banks for helping cause the financial meltdown in 2008. And those who have finally moved beyond 2008 are now criticizing the banks for a whole new panoply of sins such as being too restrictive in their lending policies, being too lenient in their lending policies, taking too many risks, not taking enough risks, etc. (Politicians and journalists do not appear to be very concerned with being consistent.)
For investors who have been brave (or contrarian) enough to venture into bank stocks, they have been quite rewarding. For example, Bank of America stock has quadrupled from its low in 2009, and since the end of 2011 it is up by 119%. Despite this type of gain, we believe that the bank stocks have a lot further to run. It probably won’t happen overnight, but if you are willing to buy and hold some bank stocks for several years, you should be handsomely rewarded.
There are a number of reasons why we like banks right now. First, they are cheap by historical measures. A number of banks today are still trading below book value; just a few years ago, many traded at two or three times book value. Second, loan growth (which, as long as the loans are made prudently, leads to profit growth) is likely to accelerate as the economy continues to improve and lending polices become a little more liberal. (After the 2008 financial collapse, many banks became ultra-conservative; in other words, closed the barn door after the cow was already out.)
Another reason we like the banks is that they are generally faring well on the government’s “stress tests” (which are probably another example of closing the barn door too late, but that’s another story). This means that the banks are less risky than in the past. Moreover, after a bank passes its stress test, the government is likely to allow it to raise dividends and initiate stock buybacks – both of which should boost the stock price.
Finally, we think banks will benefit when interest rates eventually begin to rise. With rates held low by the Federal Reserve, lending margins have been compressed, which holds down profitability. As rates rise, margins should expand, leading to more profits. The banking industry stock picks recommended in our subscriber-restricted article are a mix of money center banks and regional banks that have strong business franchises and that we think could be particularly rewarding for investors.
The airlines are another group that can’t seem to get any respect from investors. While the airlines’ past behavior provides some justification for fear and loathing, they appear to have learned their lessons. As a result, investors who are willing to let by-gones be bygones will find that airline stocks could give them a good ride in the months to come.
Over the last few decades, many of the airlines went through boom and bust cycles. When times were good, they expanded rapidly, buying new planes, adding routes, adding debt and letting operating costs creep up. Then there would be an economic downturn, and the companies would be unable to cut back fast enough, and so they would be forced into Chapter 11 – or even Chapter 22 or 33 (the informal name for a company’s second or third bankruptcy). Having been burned a few times by this behavior, investors became very reluctant to buy airline stocks, even when the financial results looked pretty good.
Now, however, the airlines appear to have finally mended their ways. After US Air, Delta and United emerged out of Chapter 11 bankruptcy in the mid-2000’s, the carriers began to show some discipline. They did not expand rapidly when things were good in 2005-07, and they cut back rapidly at the first hint of the 2008 downturn. They have continued to show good discipline ever since. The result is that planes are full, and the companies can raise ticket prices and charge extra fees for many services that used to be free.
But many investors are still unwilling to buy airline stocks because they expect the carriers to revert to their past behavior pattern. As a result, the stocks look cheap. Earnings and cash flows are strong and growing. Moreover, the coming merger of US Air and American will further reduce both capacity and competition, which should boost profitability across the industry. There is always a risk that some airlines might go back to their bad ways, but we don’t expect that, and we think the gain potential outweighs that risk. Moreover, if cash flows remain strong, we might even begin to see some meaningful dividend paying stocks.