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When a cheap financial stock is not a bargain

Although U.S. financial stocks may be down in price, they still can’t be called good buys, says this advisory — but it does make one exception.

Yesterday, one of Canada’s big five banks issued a report that wasn’t as dismal as predicted — only a 27 per cent drop in profit.

And it’s the one that has gotten the best marks for comportment during the credit crisis. It’s TD Bank, in case you missed the headlines.

A nearby headline flashed the news that more public funds would be shovelled to U.S. banks via the purchase of preferred shares.

And therein lies the rub. Despite the greater strength of our banking system, we can’t escape the infection of America’s insolvency.

That’s where the whole problem started, and that’s where the cure for this epidemic has to be found.

That’s where we’re headed today, courtesy of Dow Theory Forecasts. “Eventually, financial stocks will mount a sustained rally and investors will make a lot of money,” says this venerable Wall Street advisory. “The question is when.”

The short answer is that it may be a long wait.

For the full answer, the advisory casts a critical eye on the notion that a cheap stock is a good buy. In this sector, that’s just not so, with one rather interesting exception which we’ll get to in a bit.

Waiting for the ‘all clear’

“On the surface, the financial sector looks cheap and overdue for a rebound,” says this advisory. But it looked cheap a year ago! And that was “before the credit crunch blossomed into a global meltdown.”

Nobody knows when financial stocks will break out of their funk. In fact, adds the advisory, “history teaches that when the stocks finally do begin a sustained rally, many investors will be on the sidelines, waiting for an ‘all clear’ signal that never materializes.”

Timing is everything, adds the advisory. So start looking for opportunities now, but don’t start counting on overnight profits.

The grim facts

Here are the grim facts. The average U.S. financial stock is down 47 per cent over the past year. The S&P 1500 Index (a composite of all three Standard & Poor’s indexes, large, mid and small cap) holds 260 financials stocks. Of those, 245 have declined.

Roughly half of those stocks have seen their prices cut in half. As a result, the average financial stock now yields 4.9 per cent, more than double the norm since 1994.

And another unhappy milestone is in sight. 2009 is shaping up as the worst year for dividends since World War II.

Then there are the various ratios investors can consult. They’re out of whack too.

In limbo

Price/earnings ratios (P/E) have contracted from 17.5 a year ago to around 14.5 times trailing earnings for the financial stocks on the S&P 1500. Generally, the lower the ratio, the better the prospects for growth.

But falling prices and deteriorating earnings have pushed these stocks into a sort of P/E limbo — they’re neither fully valued nor promising to move in that direction in the foreseeable future.

The price-to-book-value (P/B) of financial stocks is very low. Normally, this is a signal to get in on the action. You’re getting more assets for your investment dollar. But that’s not the case right now, says the advisory.

“P/B ratios can be low without being cheap, and investors should put little stock in financial companies’ book value, also called shareholders equity, until the market has a better handle on what troubled debt is worth.”

Not least, there’s that benchmark of bank profitability, return on equity (ROE). It’s at its lowest point in at least 14 years.

“All things considered,” sums up the advisory, “it seems premature to conclude that the worst is behind the financial sector. Intriguing names are available at seeming bargain prices. But an uncertain economic backdrop, the unknown impact of government intervention, and a murky earnings outlook temper our enthusiasm for the sector.

“And until many institutions rid themselves of the mountain of bad assets they carry, stocks could continue to languish.”

In the whole financial sector, there is just one stock that Dow Theory Forecasts recommends.

Ducking trouble

The stock that gets the nod is in the insurance business. It is, most famously, the company that has gained a high public profile thanks to a duck. It is Aflac (NYSE-AFL).

Until a few weeks ago, says the advisory in a muted play on words, Aflac “had ducked most of the problems plaguing its peers.” Not unlike the TD Bank, in fact. But no one is fully immune these days.

Aflac’s stock plunged in January on fears that banks connected with its $9.1 billion portfolio of hybrid securities could be nationalized. Ultimately, the securities were priced down from book value, and Aflac ended up with $1.2 billion in investment losses in the December quarter. That was still less than 2 per cent of its $68.55 billion in investments and cash.

The stock is still well down this year, but the outlook for 2009 is much better for Aflac than for most U.S. financial firms. Sales are expected to rise as much as 5 per cent in the U.S. and Japan, while per-share profits are due to rise between 13 and 15 per cent.

“Aflac’s continued rollout of cancer and medical insurance sold in banks and post offices should drive much of that growth in Japan,” says the advisory. Trading at 4 times 2009 per-share profit estimates, Aflac is a Long-Term Buy — that is, a good buy over the next 24 months.

In short, while most financial stocks are not yet worth picking up at today’s cheap prices, Aflac is. There is light at the end of its tunnel. The price is $16.40. As for the rest of America’s financial stocks, until they can prove they’ve got something in their vaults besides bad debt, stay away. A cheap stock is only a good stock if it’s sure to get expensive fairly soon.