The Big Bank Theory| Leeb's Market Forecast Analysis and Tips

Citigroup and Wells Fargo are largely immune to rising mortgage rates

Dividend-paying stocks, basking in their shiny new tax status, stole the income-investing limelight last year. Look for a repeat performance in 2004. With the S&P 500 yielding 1.2 percent and 10-year Treasuries 4.3 percent, stocks with any sort of reasonable payout and attractive fundamentals are the income investor’s best bet.

Specifically, we are focusing on stocks with solid growth prospects and a yield at least double the S&P’s—i.e., 3 percent or better—a combination offering potential total real returns of 8 to 10 percent. Two top-notch financial stocks fit the bill.

Don’t let Citigroup’s strong stock performance in 2003—up more than 35 percent – scare you off. At 13 times earnings, this financial top dog is available at nearly the same valuation as more run-of-the-mill competitors. Citigroup’s size helps insulate it against the jarring effects of interest rate rises while letting it take advantage of global economic recovery. In contrast to an institution such as Washington Mutual—whose share price recently tumbled because of problems stemming from the mortgage-refinancing plunge—Citigroup is well diversified and far less dependent on rate-sensitive products like mortgages. Its offerings range from credit cards to ATMs to loans to investment banks to you-name-it. Equally important, Citigroup has embraced the global economy, with nearly 40 percent of its business carried out overseas. With the bank a presence in more than 100 companies, the Citigroup brand’s reach is massive. Exposure to rapidly growing economies in China and India will help it sustain double-digit earnings growth. Icing on the cake is the current yield of nearly 3 percent, which makes it a perfect fit for our Income Portfolio.

While Citigroup has grabbed headlines with large acquisitions, California-based Wells Fargo, now the fourth-largest U.S. bank, has steadily built upon its remarkable franchise, using its nearly 200 acquisitions over the past five years to amass a growing array of products it can market to its customers. Concerns about Wells Fargo’s position as the biggest originator, and second-biggest servicer, of mortgages in the U.S. have held down its stock market performance, but the company’s exposure to rising mortgage rates should be minimal. That’s because its home-mortgage-related operations, which make up approximately 17 percent of the company’s business, are a key element in the bank’s ability to “crosssell” its products. Currently Wells Fargo sells more than four products per customer household and is looking to raise this to eight. Cross-selling—a banking buzzword rarely actually achieved—accounts for nearly 80 percent of the company’s revenue growth and will dampen losses in mortgage origination fees. In addition, the company recently has acquired various investment and insurance businesses, further diluting interest-rate-sensitive divisions’ contributions to earnings growth. Management has set goals of 1.75 percent plus on long-term return on assets and 20 percent or more on return on equity. We believe these goals are obtainable, as Wells Fargo translates its unique banking franchise into stellar profitability.

Further evidence of Wells Fargo’s exceptional positioning is that this 150-year-old bank is No. 1 in Internet banking, while Moody’s has rated its bank-related debt AAA, the only bank to garner such a high rating. Trading at 14 times earnings, with double-digit growth in both revenues and profits, Wells Fargo is a great way to gain a stake in a superlative franchise while picking up a 3 percent plus yield to boot.

UPDATE Philadelphia Suburban has changed names and symbols to better reflect its recent water utility purchases across the U.S. It begins trading as Aqua America (WTR) in mid-February.