Benjamin Graham is considered the father of value investing. The famous Columbia Business School professor, who taught Warren Buffett, used to talk about the whimsical "Mr. Market," a fellow who would show up at your door offering to sell a company at one price one day and another price another day, often with no relation to the intrinsic value of the business. Graham counseled investors to wait patiently, buying only when Mr. Market is offering to sell those shares to you at a discount. (It worked for Buffett!)
Well, folks, Mr. Market is knocking, and he's got a deal that you shouldn't refuse.
Citigroup (NYSE: C ) released its second-quarter earnings this week, and while profits were up 4% over last year, the results fell short of Wall Street's expectations. Prudential Securities analyst Mike Mayo, whom I know, downgraded the company to neutral from overweight, citing rising costs and "lack of a catalyst." Predictably, the stock sold off.
Without question, Citigroup is a world-class company. By all measures -- assets, capital, profitability and global presence -- it ranks either No. 1 or No. 2 in the world. In terms of value, when you look at things such as P/E ratios, return on equity, dividend, and earnings yield, Citigroup sports far more value than its peers. Yet in the past two years, the stock has been flat. Compare this with the performance of Bank of America (NYSE: BAC ) for example, which racked up about a 20% gain, or JPMorgan Chase (NYSE: JPM ) , which posted a 17% rise. Even the S&P Bank Index was up about 11% in that same period.
What's the problem with Citi?
Market pundits have various theories on Citigroup's low valuation. Is it too big? No, if globalization has taught us anything, it's that economies of scale are important. Too complicated? That's not a valid excuse, either, since asset securitization and derivatives are part of the global financial landscape and won't be going away anytime soon.
So what is the problem? The answer: probably nothing. Citigroup just lacks a catalyst. I've seen situations like this so many times in the past. Stocks get ahead of themselves and become overvalued, and Citigroup was no exception. It happened back in the late 1990s, when the stock was selling at a 40 P/E. Believe me, it takes time to work off that kind of excess. However, the job was likely finished by October 2002, when the stock fell into the mid-$20s.
Over the ensuing two years, Citigroup stock doubled, and things were starting to look good again. The global economy was picking up, consumers were experiencing a resurgence, real estate was starting to boom, and interest rates were at 40-year lows. Everything looked in place for the stock to break out to new highs -- until the Fed started tightening rates. Naturally, the stock price started to discount an impact to the bank's huge consumer lending business.
Another two years have passed since then. We've witnessed 17 consecutive Fed rate hikes, and the stock sits basically where it was when all this began. This, I think, is no small feat. It's a testament to the company's deep value. Just look at the numbers. With a 10.5% earnings yield, an 18% return on equity, and a 4% dividend yield, the stock is screaming for you to buy it and put it away.
Regarding the rising costs and other concerns expressed by analysts, well, they could quite possibly be right. However, at the same time, they may be missing the bigger picture -- that interest rates might soon peak. On Wednesday, in testimony before Congress, Fed Chairman Ben Bernanke suggested that the economy might be slowing. If that were the case, he added, it could put downward pressure on inflation. The implication is that the Fed may soon be able to end its rate-hike campaign. Those comments triggered a big rise in stocks and bonds (which had been lower before Bernanke), with the S&P Bank Index jumping about 2.5%.
The end of rate hikes could be exactly the catalyst for Citigroup that Wall Street is looking for. If money starts flowing back to the big banking names again, it's hard to make a case where Citigroup wouldn't emerge from the pack. The share price sports so much value now that it could quickly become the leader of the sector once again.
Foolish final thoughts
Every time the crowd starts to become disenchanted with a stock, my contrarian juices begin to flow. When the mood sours and the broker downgrades begin to fly like rotten tomatoes, I begin to feel like wild horses couldn't stop me from buying the company in question.
However, because I am disciplined and understand that the right behavior separates the winners from the losers in investing, I never just jump right in -- instead, I evaluate stocks carefully. Negative sentiment's good, but negative sentiment combined with good fundamentals, a world-class company, and a cheap stock price is even better. Citigroup definitely fits the bill.
Fool contributor Mike Norman is the founder and publisher of the Economic Contrarian Update and is a Fox News business contributor. He is also the host of BizRadio Network. He owns shares of Citigroup but holds no financial position in any other stocks listed. The Fool's disclosure policy is worth its weight in gold.