Last week, I shared the background and overall asset allocation for my recently introduced “Conservative Growth/Balanced Model Portfolio”. You can refer back to the article or visit my website to learn more. As I stated in the previous article, the equity component of the portfolio is overweight relative to the S&P 500 in the Industrial, Consumer Discretionary and Financial Sectors. I previously shared my basis for taking these exposures.
In previous articles, I reviewed my selection of an Energy stock, Chevron (CVX), that qualified for inclusion and then my reasons for including three Industrials: Administaff (ASF), Carlisle Companies (CSL), and Illinois Tool Works (ITW). This week, I also addressed another "overweight" sector, Consumer Discretionary, where we started the model with positions in Bed Bath Beyond (BBBY), Columbia Sportswear (COLM) and Lowe's (LOW). I followed that up with a review of my selection in Consumer Staples, Walgreens (WAG), and in Healthcare, Johnson & Johnson (JNJ). Today, in the penultimate article, I want to share my thinking behind the two Financials, Cullen/Frost Bankers (CFR) and Federated Investors (FII).
For those not familiar with CFR, it is an extremely conservative bank based in Texas with a large money-management operation. The bank sees its strength in its relationship management. I see further strength in the foresight that management has demonstrated, including an early exit from mortgage lending, avoidance of credit card lending and a well-timed interest-rate swap that protected them from plunging short-rates. The bank is deposit rich and lends in Texas alone, which isn't such a bad place to conduct business these days. The bank has grown both deposits and loans recently. The former is a bit surprising given how aggressive competition has become for deposits. Clearly, customers value the perception of safety at CFR.
I like CFR because it should actually do better in this environment, enjoying a steeper yield curve, reduced competition from beleaguered larger out-of-state banks and deposit growth from wary investors. While the PE isn't that different from its median over the past 10 years, it is important to recognize the probable increase in earnings ahead. On a P/B basis, the stock is near a 12-year low. The company has increased its dividend in each of the past 12 years, and the stock yields over 3%.
FII, which was just hit on an earnings miss, is a diversified mutual fund and separate accounts manager. It has a massive money-markets fund operation as well as a broad range of equity and fixed-income products. I like the industry a lot - huge returns on capital, high barriers to entry (at least in order to reach sufficient scale), long-term demographics that favor saving/investing and recurring revenues. While the industry has been hurt by the bear market, valuations look great. FII trades at its lowest multiple since 1999. The company has 14% inside ownership and pays a 2.8% dividend that has been increased in each of the past 10 years. The balance sheet is debt-free, and the company generates significant free cash flow. FII and its peers are "safe" Financials, a good bet for those who believe that the credit crisis will be sticking around for a while.
The two picks in the portfolio could benefit as investors redeploy capital into the Financial sector. Unlike their troubled counter-parts, these two won't be issuing stock. In fact, each of them could be an acquirer of divestments from troubled banks looking to shore up their balance sheets. I believe that there is a little bit of the "baby-in-the-bathwater" syndrome at play and expect both of these companies to enjoy a bit of PE expansion on top of earnings growth despite the overall negative tone for the sector.
Disclosure: Long CFR and FII