I buy stocks the same way I shop for clothes.
When I go shopping for clothing, I always start at the clearance rack. The prices are great, but there is usually something wrong with the merchandise. Sometimes the problem is just a missing button, and sometimes I find something that is that shade of neon that was popular in the 80's.
With stocks, I start with a company that has cheap stock and try to determine if it's cheap for something fixable (the missing button) or permanent (the neon.)
Citigroup's no good, very bad year
Citigroup (NYSE:C) has had a rough 2014 to date. Citigroup announced it is dealing with two separate instances of customer fraud in its Mexican subsidiary and may have lost over 400 million dollars. What really caught investors by surprise, though, was the Federal Reserve Board announcing that it had objected to the capital plan submitted by Citigroup as part of the 2014 Comprehensive Capital Analysis and Review (CCAR.)
This objection by the Fed was especially surprising considering how well Citigroup had performed during the Fed stress tests which occurred the week prior to the CCAR. Citigroup maintained a 7.2% tier one common ratio under the severely stressed condition, which exceeded the Fed minimum threshold of 5% by a healthy margin. However, the Fed found issues in the bank's "ability to project revenue and losses under a stressful scenario for material parts of the firm's global operations, and its ability to develop scenarios for its internal stress testing that adequately reflect and stress its full range of business activities and exposures."
With the CCAR embarrassment and the fraud allegations in Mexico, there is some very warranted concern that the bank lacks the internal controls to properly manage itself. However, investing is the process of finding a price of a security where the reward justifies the risk. I believe we're at that point with Citigroup.
Citi is dirt cheap
Due to the cyclical nature of the banking industry, banks are typically valued on a price to tangible book multiple rather than price to earnings. US Bancorp (NYSE:USB), a stable bank with a great track record for creating value, trades at over three times its tangible book value.
Even Bank of America (NYSE:BAC), which certainly is not without major problems of its own, trades at 1.1 price to tangible book value. Citigroup, on the other hand, trades at a rock-bottom 0.85 times tangible book.
The market is so pessimistic about this bank that it is essentially saying the company's stock is worth 15% less than the liquidation value of its assets.
This depressed price is a short-term reaction to the CCAR objection and the fact that investors are disappointed that the long-anticipated dividend increase will be put off another year. Long-term investors know the money that Citigroup holds onto in 2014 instead of paying out a dividend still belongs to them, though. Citi can use this year to strengthen its capital ratios and invest in growth. The meaningful dividend hike and buyback will come in 2015.
Citi lets you profit off the world's growth
A whopping 56% of Citi's revenue comes from outside of North America, with 40% coming from Asia and Latin America.
According the IMF, "developing economies" in Asia and Latin America have contributed higher GDP growth rates than the "developed" economies in the western hemisphere and Europe. Citigroup, with its global reach, is better positioned than most banks to invest in whichever economies are most promising.
Citigroup has warts. The bank is turning around slowly, and there are legitimate concerns about its internal controls. Citi's problems are fixable, though, and I took the plunge and bought shares. It is already a global powerhouse in a way that would be nearly impossible for other banks to replicate. A number of short-term events have caused the company's stock to drop further than it should have, creating a nice buying opportunity for patient investors.
The lack of a dividend increase in 2014, while disappointing to those seeking more of the bank's profit returned to shareholders, does not materially change the value of the enterprise. Citigroup's turnaround is a multi-year story. If the bank remains steady, though, the price to book multiple will climb as book value climbs. This will give investors a double-whammy of reward for their risk.
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Chris Walczak owns shares of Citigroup. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America and Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.