Are These the 2 Best Financial Stocks in 2014?

These two companies offer investors asymmetric reward potential as their earnings and asset quality normalizes, and investor perceptions about their growth outlook should change.

Sep 2, 2014 at 9:41AM

Considering that the stock market has had a fantastic bull party since March 2009, should you still even buy stocks? If so, what sectors and stocks should you weigh investing in? 

Well, I think you should. Those investing for the long term still are looking at an attractive risk to reward ratio given the current state of the economy. Most stocks have increased dramatically in value over the last five years, as the S&P 500 and Dow Jones Industrial Average staged strong comebacks after the financial crisis, but some companies retain sizable upside potential.

The U.S. economy is still plodding along, and investors generally do not seem particularly optimistic. Just consider Federal Reserve chief Janet Yellen's recent statement that "the labor market has yet to fully recover" from the depths of the financial crisis.

We have not dug ourselves out of the hole just yet, and the U.S. economy has a lot more room to grow. But the latest economic data is encouraging: U.S. GDP grew 4% on an annualized basis in the last quarter, while inflation remains low for the time being.

Given the improving economic fundamentals, I think these two companies can benefit handsomely from a better earnings outlook:

1. Bank of America
I like this bank that so many investors seem to have given up on due to its mortgage mess. Bank of America (NYSE:BAC) continues to be my favorite bank investment in the large market capitalization category.


Source: Company.

The bank just announced a landmark settlement with the Department of Justice to rid itself of accusations of shoddy mortgage practices. Bank of America's stock has been kept down for years by fears about mortgage-related litigation, so the settlement should clear the way for new growth initiatives.

In addition, Bank of America has a strong consumer banking franchise that should serve it well when GDP growth rates normalize.

Investors are still largely skeptical about the bank, as evidenced by a massive discount to book value: Investors can still grab this leading commercial bank at a 23% discount to book value, which indicates a significant margin of safety.

Going forward, Bank of America should benefit from normalizing earnings, improving asset quality, and possibly stronger cyclical investment banking earnings. All of this should help reduce the gap between book value and share price.

2. Ally Financial
Another interesting bet on improving economic fundamentals and higher profitability is Ally Financial (NYSE:ALLY). This financial services company with a focus on auto finance is still largely flying under the radar for many investors. Ally Financial somewhat suffers from a bad reputation as it was one of the high-profile victims of the financial crisis.


Source: Company.

The company was previously General Motors' financing arm, was bailed out by the government, and returned to the capital markets in April 2014 as a leaner company.

With the hardest part of restructuring now in the rearview mirror, Ally can concentrate on building its business and delivering growth.

Ally Financial currently achieves single-digit core returns on tangible common equity (6.5% in first-quarter 2014, 8.4% in the second quarter), but has taken steps to tackle costs and formulated its ambition to achieve even higher returns on equity in the future. Plus, Ally's profitability trend looks encouraging considering that the company last year only achieved 2%-3% returns on tangible common equity.

Furthermore, Ally Financial also trades at a discount to book: Though its 13% discount is not as whopping as the 23% discount for Bank of America, it shows investors still are somewhat pessimistic about the company.

Similar to Bank of America, investors don't seem to grasp the potential for value creation a couple years down the line. And that's exactly where the opportunity lies.

The Foolish takeaway
I think financial companies are the place to be during the next couple years as macroeconomic developments support investments in growth-sensitive businesses such as banks and financial services firms.

Bank of America and Ally Financial are promising investments in the financial sector that continue to offer investors asymmetric reward potential.

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Kingkarn Amjaroen owns shares of Bank of America. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. 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.

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