U.S. stock markets are now factoring in more than a 50% chance that the Federal Reserve will increase the Fed funds rate in June or July.
Rate hikes are positive for most financial stocks because the companies then earn increased fees on customers’ deposits. In addition, withering expectations of a global recession are fueling growth prospects for financial institutions, bringing increased investor attention to the sector.
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Consequently, bank stocks are turning bullish, with stock price charts surprisingly in synch with each other.
With that backdrop, I took a look at banks to see which have undervalued stocks that could make for excellent investments. I certainly did not expect to discover that almost every single bank stock that I reviewed was expected to see earnings fall this year!
You think I’m exaggerating, right? Earnings are falling in fiscal 2016 at Bank of America (BAC), Citigroup (C), Deutsche Bank (DB), Fifth Third Bancorp (FITB), J.P. Morgan (JPM), Morgan Stanley (MS), State Street (STT) and Wells Fargo (WFC).
In addition, there are a few more prominent banking companies slated for slow earnings growth (<10%) in 2016: Bank of New York Mellon (BK), Northern Trust (NTRS) and U.S. Bancorp (USB).
But I did find one bank that’s an undervalued stock with strong earnings growth.
The Clear Choice Among Bank Stocks in 2016
My investment strategy involves a set of strict investment criteria, with strong, current-year earnings per share (EPS) growth being my first requirement. Therefore, none of the stocks I’ve mentioned has a chance to land on my buy list until we approach fiscal 2017.
I’m not saying that these bank stocks won’t rise in 2016. What I’m saying is that, when stocks rise, the ones with stronger earnings growth stand a better chance of rising farther, over a longer time frame.
My job is to find the cream of the crop value stocks in each industry, which increases investors’ chances of achieving capital gains—because if I can find the best undervalued stocks, you can be sure that institutional investors will buy those stocks in large quantities, driving the prices up.
And my research shows the undervalued bank stock best positioned for earnings growth is Goldman Sachs Group (GS).
Goldman Sachs is a global investment banker, serving consumer, institutional and government clients. The company is expected to fare well in the second half of 2016, as oil prices and stock markets rise, and M&A and underwriting business improves. In addition, Goldman is expected to gain market share in Europe vs. weakening competitors in the EU.
Increased revenue expectations are contributing to rising operating margins, which are expected to grow from 31.3% in 2015 to 35% in 2017.
P/E is Low and Earnings Outlook is Strong
Goldman’s EPS fell in 2015 due to the cost of a settlement imposed on a wide variety of investment bankers over residential mortgage-backed securities litigation. An earnings rebound is expected immediately. Wall Street’s consensus EPS estimates reflect 19.8% and 21.5% growth in 2016 and 2017 (December year-end).
The corresponding price/earnings ratios (P/Es) are quite low in comparison, at 11.1 and 9.1. In recent years of normal earnings growth, the P/E on GS ranged from 8 to 12. Now that the company is producing outsized earnings growth, there’s room for P/E expansion.
I think that any investor who wants to own a bank stock has the decision made for them: Goldman Sachs so dramatically outranks its competitors today on earnings growth and valuation, that it’s the clear choice among bank stocks in 2016.
Goldman’s share price peaked in October 2007 at 235, prior to the infamous 2008 financial meltdown, but continues to recover. GS rose as high as 215 last summer, pulled back with the more recent rough patch in the stock market, and has been slowly rising since mid-February.
The share price appears to have just completed a short-term correction. Investors who buy now will be getting quite a bargain. Barring unexpected negative news, I expect the share price to rise to 166, rest briefly, then to promptly rise to additional upside price resistance around 175.
GS is an undervalued stock with a 1.6% dividend yield.
To capitalize on the trend of rising interest rates, you should own at least one bank stock in your portfolio this year. My recommendation is to buy the only big-name bank stock with strong earnings growth in 2016: Goldman Sachs.
The best choice seems crystal clear.
To receive additional investing advice and further updates on GS, consider trying our new advisory, Cabot Undervalued Stocks Advisor. For details, click here.
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