Since becoming a stand-alone public entity in the fourth quarter of last year, Citizens Financial Group (NYSE:CFG) has crushed the markets. The regional bank, formerly a subsidiary of the Royal Bank of Scotland, is up 21% since its IPO versus 6% for the S&P 500 over the same period.
The stock's upside hasn't gone unnoticed: Over the past few quarters hedge funds have bought the stock in huge numbers. Which hedge funds are buying Citizens Financial, and why? Let's find out.
Who's buying Citizens Financial Group?
Using data aggregated by the analytical firm Novus, we can analyze the portfolios of the largest and most influential hedge funds on Wall Street and elsewhere. The data is pulled from each fund's required portfolio disclosures to the SEC and is limited to hedge funds with long positions in public equities.
Based on the data, more hedge funds bought Citizens Financial Group stock in the first quarter than any other company in the financial sector. Forty-four funds opened new positions in the bank in the quarter, far outpacing the two stocks tied for second place with 26 new hedge fund positions each: Bank of America and American Express.
Notable funds includes David Einhorn's $8.8 billion Greenlight Capital, which owns a $332 million position, and Robert Pohly's $6.3 billion Samlyn Capital, which owns a $192 million position. In total, 72 hedge funds had open, long positions in Citizens as of the first quarter.
Why are hedge funds so bullish on Citizens Financial Group?
In Greenlight Capital's investor letter in fourth-quarter 2014, Einhorn explained his bullish theory for Citizens Financial:
While [Citizens Financial] is overcapitalized and currently generates a low [return on equity] relative to peers, it plans to improve its ROE over the next two years through a combination of loan and fee income growth, cost reductions, capital return, and a partial normalization of interest rates. We purchased [Citizens Financial] at $22.01, a discount to tangible book value and a significant valuation discount to its banking peers. Over time, we believe the eventual exit of RBS and improvement in CFG's ROE will drive improvement in the stock's valuation. [Citizens] management received stock incentives at the time of the IPO, aligning their interests with shareholders.
In other words, because Citizens is in a time of transition, the market is undervaluing its intrinsic value and future potential. Based on Einhorn's $22 entry price, he's already in the positive by over 25% as of this writing.
The bank currently trades at a price-to-book value of just 0.76 times. Generally, bank stocks are considered cheap if the price-to-book ratio falls below 1. For context, Bank of America trades at a similar discount at 0.81 times, while industry leader Wells Fargo trades at 1.77 times.
As Einhorn noted, that discount is driven by the bank's low returns on equity and assets. On a trailing 12-month basis, Citizens' ROE is just 4.67%. Wells, by contrast, returned over 14% for the same period, justifying its higher relative valuation.
What must happen for the hedge funds to profit on this investment
The path to higher returns for Citizens is, at least in theory, straightforward. The bank must maintain its commercial business's performance while improving the retail side.
The bank's commercial division returned 13.5% on equity for the first quarter of 2015. It did that with a lean 46% efficiency ratio and 1.43% return on assets. That's a strong performance compared to even the most elite U.S. banks.
The retail side, on the other hand, needs some work. Return on equity from retail operations was just 5.3% for the same period. The efficiency ratio was a bulky 79.25% and return on assets was just 0.48%. It's worth noting that these numbers all improved quarter over quarter and year over year, even if the division still has a long way to go.
For this turnaround story to succeed, the bank clearly needs to cut costs in its retail division. It's too early to say if management can successfully accomplish this, but early indications are positive.
Noninterest expenses in the retail division dropped by $15 million from fourth-quarter 2014 to first-quarter 2015. Noninterest expenses also were down $42 million year over year. As a result of these improvements, the division's net income jumped 17% from the fourth quarter to the first quarter and 91% year over year.
If this turnaround story resonates with you, you're not alone. The hedge fund industry has bought into Citizens Financial's story and is investing hundreds of millions into the stock. Now that the bank is a stand-alone and publicly traded entity, you also can invest.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends American Express, Bank of America, and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. 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.