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3 Financial Stocks to Take a Flier On

Major financial stocks remain unpopular with many investors, and it’s obvious why.

Citigroup (NYSE:C) and Bank of America (NYSE:BAC) remain bailout poster children, throwing off a measly 1-cent dividend quarterly as the Federal Reserve continues to scold them over capital reserves. JPMorgan Chase (NYSE:JPM) can’t seem to shake the drag of the London Whale debacle and constant government haranguing.

But if you can look past some of the warts in the sector, you might find a few financial stocks worth pursuing right now.

Book Values: It was easy to understand why banks traded at a fraction of book value during the financial crisis — since nobody knew what the heck banks had on their books and what those assets were worth. That has corrected for some, including Wells Fargo (NYSE:WFC), which is now trading above book value. Still, at worst many of these players are fairly valued — JPM, for instance, is almost exactly 1 in the price/book department. Others from BofA to midsized players like Regions Financial (NYSE:RF) to smaller financials like First Niagara (NASDAQ:FNFG) trade for at least a 20% discount to book value. Historically, 1.5 times book value was pretty fair, and peak valuations were as high as 2.3 times book in the late 1990s and early 2000s.

Lean and Mean: Nobody likes layoffs, but it’s worth noting that banks have trimmed operations even as they have improved their balance sheets. Layoffs since 2008 totaled about a half-million through early 2012, and the hits have kept coming. JPMorgan, for instance, just announced a 1.5% staff reduction that will eliminate 4,000 jobs despite an improving stock price, balance sheet and loan portfolio.

Winding Down Risk: Banks that are at risk of failure continue to be less common, as evidenced by the “unofficial problem bank list” at Calculated Risk as well as the continued decline in failed banks closed by federal regulators. As we approach the end of Q1, we have just four banks that have been wound down vs. 16 in the first quarter last year and 26 in Q1 2011. This is a sign of improving health for the industry.

Improving Lending: According to the FDIC, banks nearly earned a record amount of profits last year thanks to improved lending. This has been fueled particularly by the resurgent housing and mortgage market, but also loans to commercial borrowers.

Improving Cash Cushions: Despite brisk lending, banks continue to shore up their balance sheets with bigger cash reserves. Some institutions, including Bank of New York Mellon (NYSE:BNY), have Tier 1 Capital reserve ratios that are as high as 15%. A host of others, from GM spinoff Ally (NYSE:GKM) to PNC (NYSE:PNC), are in the double digits. (Check out full details for the 18 largest U.S. banks.) This Tier 1 capital is crucial to absorbing losses and preventing both systemic risk and problems for individual banks.

There are other reasons to be bullish too, including …

  • Hopes of a broader economic recovery across the next few years, fueling lending.
  • Net interest margin (and thus profits) will improve if and when the yield curve steepens.
  • After this Cyprus mess, American banks are looking increasingly attractive to investors compared with counterparts around the globe.

So what banks should be on your shopping list then, if you believe these trends? Here are three I like and why. I encourage you to do your own research, but here are the highlights to get started:

SunTrust (NYSE:STI): I like regionals in particular because housing moves them more. SunTrust is a good play because it is smaller than the big boys but still has scale ($15 billion market cap) to provide stability. SunTrust has largely underperformed in the past year thanks to failing its 2012 stress test and some revenue concerns, but that might provide an opportunity to get in before the run as opposed to buying some picks like JPM that could settle down after recent big runs. A good stress test reading this time around means the company can buy back stock and double its dividend, which also helps.

Nicholas Financial (NASDAQ:NICK): This is a favorite of my friend Ed Elfenbein over at Crossing Wall Street, and with good reason. This isn’t a conventional bank, but instead focuses on car loans through a network of more than 63 branch offices. Just as the housing market’s recovery has been a boon to mortgage lending, continued strength in auto sales means better profits for NICK. In 2012, U.S. light-vehicle sales hit 14.5 million — the highest level since the Great Recession — and continued growth is expected this year to as much as 15.3 million vehicles. This tailwind will be great for Nicholas Financial.

Wells Fargo (NYSE:WFC): If you want stability, it’s hard to find a better bank than Wells Fargo. Last year it gobbled up the mortgage market, controlling one in every three loans. It also has long been respected as the most stable and least risk-crazed of the financial stocks. With a 2.6% yield and a great operation, if you’re looking for a long-term bank buy at the top of the food chain, this is it.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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