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Time to Buy Financial Stocks?

Published in Business Week

Some brave long-term investors are looking for bargains among the casualties of the credit crunch

by Ben Steverman, October 30, 2007

For stock investors, recent action in the financial sector has seemed like one of those theme-park haunted-house rides. Ghouls routinely pop out from the dark at every turn, scaring again and again with credit losses, mortgage defaults, market disruptions, and billion-dollar hits to the balance sheet. The most frightening thing: No one knows how long the ride will last.

Yet some investors say such terrifying conditions are a great time to start buying stock in the financial sector.

Their argument: Financial stocks in the S&P 500 have tumbled almost 10% in the last six months, while the broader index is up 2.75%. Financial giants like Citigroup (C), Bank of America (BAC), Wachovia (WB), Merrill Lynch (MER), and big insurer AIG (AIG) are all trading at or just above one- and, in some cases, two-year lows.

For long-term investors, the beat-up financial sector may be the best place to look for bargains. The shares of some regional banks, in particular, are at levels that basically price in a “worst-case scenario” of a recession, says William Fitzpatrick, an equity analyst at Johnson Asset Management. Many banks are paying big dividends of 7% or 8%. On “any sort of recovery at all, these stocks are really going to rally,” he says.

But Fitzpatrick and other expert investors warn that financial stocks are at low prices for very good reasons. Things really could go from bad to even worse.

The recent troubles at Merrill Lynch give an idea. At first, the U.S.’s largest brokerage said it expected $5.5 billion in losses in the quarter from losses in mortgage-backed debt and other credit troubles. Less than a month later, that number was up to almost $8 billion.

“When there’s that much change in a few weeks, it just shows the complexity of these instruments, and that they were getting involved in areas they didn’t understand,” says Alan Lancz … [President of Alan B. Lancz & Associates, Inc.].

If it’s tough for even company insiders to understand the impact of the summer’s credit disruptions, it’s that much harder for the average investor.

Still, some hope that a lot of the damage out there has already been reported. “I think most of the firms parked all the bad news in their third-quarter earnings,” says Scott Armiger, portfolio manager at Christiana Bank & Trust Company (CBTD). They had every incentive to get all or most of the bad news out of the way. In the third quarter, Reuters Estimates predicts earnings for the financial sector fell 17%. Analysts surveyed expect a modest 3% increase in the fourth quarter.