There are plenty of stocks in the financial sector that can be called cheap, but that doesn't necessarily mean you should put them in your portfolio.
Just like any other purchase in life, you need to determine whether a stock is a legitimate bargain, or if it's cheap for a reason. For instance, maybe the dividend is about to get cut. Or maybe the company's customers are leaving it in favor of competitors.
Having said that, here are three financial stocks that, while cheap, offer a strong potential to outperform over the coming years. In other words, these are some of the real bargains.
A great value in banking
When it comes to undervalued bank stocks, there really isn't one with a better risk to reward balance than Citigroup (NYSE:C). At the current share price, Citigroup trades for just than 93% of the value of its tangible assets and is projected to grow its earnings by more than 60% over the next two years.
Over the past few years, the company has become much better capitalized and has done an excellent job of shedding its "legacy" assets. In fact, Citigroup's Basel III Tier 1 common ratio is actually the highest among the large U.S. banks at 10.6%, and the size of the Citi Holdings portfolio has been reduced in size by more than 61% since 2011.
Of course, a cheap stock with such high growth potential doesn't come without risk. For example, the $111 billion of Citi Holdings' legacy assets still on the balance sheet is quite substantial. The company's entire market cap is $158 billion, so any significant change in the performance of those assets could certainly cause some volatility. And Citigroup has higher exposure to emerging markets than its peers, which creates a lot of uncertainty.
Still, Citigroup looks like a bargain. Basically, you can buy the company's assets for less than what they're worth, and any future growth is a nice bonus.
An insurance play that could really pay off
Although it still faces some headwinds, Genworth Financial (NYSE:GNW) is simply too cheap to ignore right now. The company is the largest provider of long-term care, or LTC, insurance in the United States, and it also has a rather large presence in the mortgage insurance business.
One of the biggest obstacles facing the company is figuring out how to make money from its LTC portfolio, and particularly some of its older blocks of LTC policies, which are hemorrhaging money. Genworth is in the process of requesting higher rates in these policies from the individual states, and although some progress has been made so far, there is still a long way to go.
However, Genworth estimates that if all of the states allow the requested rate increases, it could mean an additional $300 million annually in premium income, and the losing policies would actually start to break even, allowing the company to start to capitalize on the future potential of the LTC business.
To give you an idea of this potential, Genworth estimates that 70% of the 78 million baby boomers in the U.S. will need long-term care services at some point, but just 10% currently have LTC coverage. And its leading market share gives it a strong advantage going forward as it rolls out new LTC products.
Remarkably, Genworth trades for just 43% of the value of its tangible assets, which definitely indicates that investors expect some bumps in the road. Still, this kind of valuation is simply too cheap to ignore, especially for a market-leading insurance company.
High yield and great management
Mortgage REITs are inherently risky, but Annaly Capital Management (NYSE:NLY) is one of the best in breed in terms of mitigating risk while still delivering incredible returns. In fact, the stock currently pays out about 11.1% after the recent market pullback.
Basically, Annaly makes money by borrowing money at relatively cheap shorter-term rates and buys long-term mortgage securities that pay more, pocketing the "spread" between the rates. For example, if it costs Annaly 1.5% to borrow money, and its portfolio pays an average of 3.5%, the 2% difference is the company's profits. So, to boost returns, mortgage REITs like Annaly borrow several times more than the value of its assets.
Annaly uses a somewhat below average leverage ratio of about 5-to-1, which the company intentionally lowered to ride out interest rate volatility, and to be able to take advantage of opportunities when rates eventually begin to rise.
And like the other two companies mentioned, perhaps the most compelling reason to buy Annaly is its valuation, which is currently just 82% of the value of its assets. So not only do you get a very large income stream, but you also have the potential upside that comes with buying the company at a discount.
Remember that no stock that trades cheaply or offers an exceptionally high dividend comes without any risk. However, in these three cases, I believe that the potential reward clearly outweighs the risk that comes with owning the stocks.
Matthew Frankel owns shares of Annaly Capital Management. The Motley Fool owns shares of Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.