2015/2016

U.S. Financials Jonathan Casteleyn, CFA, CMT - Analyst

LONGS Market Cap ($MM)

Dividend Yield Short Interest (% of Float)

Sell Side Sentiment

Fundamental Factor

Rationale Risk Units

Bank of America (BAC) $168,250 0.25% 1.0% 46% Positive Value Book value of $20 at a 10% normalized ROE is $2 in EPS – Street is at $1.30

3

Goldman Sachs (GS) $78,000 1.3% 1.9% 21% Positive Quality Institutional trading volume to benefit on rising VIX and FICC expectations are low – good pair against short MS

2

Allianz SE (ALV) $67,000 3.6% 0.5% 51% Positive Value PIMCO outflows are waning and performance is improving – great time to own this value insurer with a dividend yield

3

Capital One (COF) $48,200 1.4% 1.3% 72% Positive Value Still cheap at 10x earnings in one of the few growing U.S. loan categories

3

CME Group (CME) $29,000 2.1% 2.1% 31% Positive Quality Prime beneficiary of renewed volatility in the US – good pair against short ICE

3

Invesco (IVZ) $16,697 2.6% 1.6% 53% Positive Quality Improving distribution – UK retail fears well discounted

2

NASDAQ OMX (NDAQ) $6,700 1.5% 5.3% 61% Positive Value 40% of market share trades off exchange which will change

3

eTrade (ETFC) $6,500 0.0% 3.8% 60% Positive Momentum A potential takeout candidate with US retail back – loan book is improving

1

Och Ziff (OZM) $6,300 6.8% 1.6% 66% Positive Yield Alts have a massive tailwind with Pension reallocation – 10% fully loaded dividend yield too

2

Lazard (LAZ) $6,700 2.3% 0.3% 60% Positive Quality M&A segment is the best in capital markets – still cheap relative to group

3

Legg Mason (LM) $6,000 1.2% 7.0% 26% Positive Value Pension reallocation helps them with still high short interest and low sell side sentiment in this stock

3

Zions Bancorp (ZION) $5,537 0.5% 6.4% 24% Positive Value Regional banks can grow their loan segments with the big banks in the penalty box – ZION still under book value

3

Fortess (FIG) $3,200 4.2% 2.3% 70% Positive Value $3 per share in core management fee EPS + $3 in balance sheet assets is cheap for this $7 stock

1

Federated Investors (FII) $3,400 3.0% 9.0% 15% Positive Value My EPS opportunity is 15% above the Street and sentiment is way too low

2

Wisdom Tree (WETF) $2,400 1.7% 7.7% 66% Positive Momentum Strong grower in secular ETF boom – First mover in Fundamental ETFs

1

KB Homes (KBH) $1,400 0.6% 19.7% 25% Positive Value PHS is turning up which should pull housing equities with it. KBH is a value name out of favor

2

Ocwen Financial (OCN) $900 0.0% 9.0% 77% Positive Quality Now trading at tangible book or liquidation value – like it as a pair against Nationstar

1

Beazer Homes (BZH) $500 0.0% 17.6% 30% Positive Value PHS is turning up which should pull housing equities with it.

2

SHORTS Market Cap ($MM)

Dividend Yield Short Interest (% of Float)

Sell Side Sentiment

Style Factor Rationale Risk Units

Citigroup © $146,000 0.0% 1.2% 63% Positive Value Lots of “hope” for recovery but EM exposure will take them down and no U.S. loan growth

3

Morgan Stanley (MS) $71,000 1.1% 1.0% 37% Positive Quality Will lag GS as Vol picks up and has higher expectations now with retail recovery

2

Charles Schwab (SCHW) $36,614 0.8% 2.2% 25% Positive Momentum SCHW needs a BIG increase in short rates to justify valuation which just won’t happen

2

Intercontinental Exchange (ICE)

$21,000 1.3% 2.3% 65% Positive Momentum Core energy volumes slowing with all synergies now baked in from NYX deal

2

T Rowe Price (TROW) $20,000 2.1% 1.5% 51% Positive Quality Institutional Large Cap Equity in outflow and Fund closures to hurt their ability to net new AUM

3

Nationstar Mortgage (NSM)

$3,100 0.0% 34.5% 18% Positive Momentum Horrible accounting and MSR transfer opportunity dwindling – lots of regulatory risk

1

Janus Capital (JNS) $2,300 2.6% 19.7% 20% Positive Value Bill Gross premium is over discounted with former Total Return money not even qualifying for Unconstrained mgmt

1

Financial Engines (FNGN) $2,200 0.5% 15.2% 71% Positive Momentum Declining market share of this 401K provider – lots of insider selling and Sell Side still offsides with Positive Recommendations

1

Encore Capital (ECPG) $1,000 0.0% 32.4% 90% Positive Momentum Company has levered up to make acquisitions and now has no tangible equity capital. IRRs on purchased receivables are declining too

2

Walters Investment Management (WAC)

$1,000 0.0% 16.6% 63% Positive Momentum There is a chance this company is a zero with bad accounting and leverage and MSR opps dwindling

1

Market Thesis: I am looking for the U.S. market to tread water in 2015 and put in a moderate decline.

Markets can do four things: Go up a lot; Go down a lot; Go up a little; Go down a little. With EVERY

publishing sell-side strategist forecasting that the S&P 500 will have POSITIVE gains in 2015, this outlook

is already well discounted by the market and thus means it is NOT likely to happen. With these targets

mainly in the +2% to +9% range for U.S. stocks, I put that in the “up a little” category which takes it OFF

the table as an outcome. I think “up a lot” is not likely after 6 consecutive years of positive returns in the

S&P 500 (and for the record the S&P 500 in 140 years of data has never risen for 7 consecutive years),

and I think “down a lot” is off the table as corporate balance sheets are still in much better condition

after the Credit Crisis and general corporate risk aversion. Thus I think with corporate earnings growth

slowing into 2015, and a Fed Reserve that generally wants to get off of emergency policy and move

interest rates up slightly, I think the S&P 500 will be “down a little” in the neighborhood of -2% to -9%. I

am focused on Large Cap Value names to match this defensive posture with solid balance sheets for

Long exposure. Pair trades can be effective in this environment and also shorting Small Cap Growth or

speculative names.

All the major Sell Side Strategists are forecasting gains for the S&P 500 in 2015:

With the rate of corporate earnings growth declining into 2015 which will provide consternation to the

market:

And the S&P 500 is now ahead of the trajectory of unemployment claims which are treading water:

Sector Thesis: Both the Buy and Sell side are still off sides with respect to interest rate expectations and

thus the Financials sector should underperform. The investment community still expects rates (10 Year

Treasuries yields) to RISE throughout the year. However empirically rates have FALLEN after both bouts

of quantitative easing (QE1 and QE2) were wound down and the current tapering program is essentially

that phenomenon in slow motion so unexpectedly, U.S. ten year yields will remain stubbornly low. With

many segments of U.S. Financials still dependent on higher U.S. rates with positive correlations to 10

year yields, we broadly recommend an UNDERWEIGHT position in the sector for now. However there

are some pockets of growth in the sector that do allow for LONG exposure including a trending M&A

(merger and acquisitions market), an investable move up in volatility which should benefit the

exchanges, and a recent pickup in demand for consumer credit. In addition, one of the biggest themes

we see in the sector is the revamping of the U.S. pension fund system which is re-allocating rapidly OUT

of equities and INTO fixed income and alternatives, with funded status well improved after the 6 year

run in equities and asset allocation now a function of immunization and the pursuit of risk adjusted

returns. In this scenario we like unpopular bond manager Legg Mason and Allianz and leading hedge

fund Och Ziff. In addition, after underperforming for most of 2014 with weather related issues and also

initial tighter credit parameters, the U.S. Housing complex is starting to turn the corner and should

outperform in 2015. As such we like a handful of homebuilders and the mortgage insurers.

Conversely, we are caution on Emerging Markets and like shorting Citigroup as the U.S. bank with the

most disproportionate exposure to that region. In addition, the mortgage servicers are continuing under

intense regulatory scrutiny and what was once a $1 trillion mortgage servicing transfer opportunity from

the wire house banks continues to be whittled down. Lastly, some of the debt collectors have levered up

and are buying low IRR paper which could really compress earnings, which makes them good short

candidates. In the aforementioned rotation out of Large Cap Equities, our favorite short is T Rowe Price

(TROW) and secondly Janus Capital (JNS). On the mortgage servicers side we like shorting Nationstar

(NSM) and Walters (WAC), and our favorite short in the debt collectors is Encore Capital (ECPG).

RATE TRAJECTORY IS STILL NOT WIDELY UNDERSTOOD:

Rates as defined by the U.S. 10 year yield empirically DECLINE when the Fed removes quantitative

stimulus. This is NOT widely understood as the bulk of the investment community believes that if a big

buyer of securities is REMOVED from the market (i.e. the Fed from the rate curve), that Treasury prices

must FALL and hence the 10 year yield must RISE. However, the OPPOSITE actually happens as growth

expectations for the U.S. economy FALL with the REMOVAL of stimulus and hence 10 year yields

DECLINE. I view the currently tapering program as a slow motion version of the end of QE1 and QE2

where rates FELL 100 bps in each case. Thus U.S. rates should stay stubbornly low which will hurt many

of the long cases for U.S. Financials.

STILL A RATE SENSITIVE SECTOR:

Running the impact of the trajectory of rates against the major constituencies of the sector, displays the

dependency on 10 year yields. For example the average R value of the Banks and Thrifts segment against

10 year yields (we ran the correlation of stock prices to 10 year yields over the past year) is 0.62. So

roughly 1/3 of the price response of the banks (with an R-squared of 0.36) is explained by rates. The

Banks and Thrifts have the most sensitivity to rates with the Brokers and Asset Managers next, followed

by Specialty Finance, Insurance, and the Homebuilders which are negatively correlated to rates.

BOTTOMS UP SECURITY SELECTION: Just a few charts and thoughts that crystallize our views on our

security selection:

Long OCH ZIFF (OZM) and LEGG MASON (LM) on U.S. pension re-allocation and Short TROW PRICE

(TROW) and Janus Capital (JNS)

The biggest theme in our view is the rotation in the U.S. Pension fund system AWAY from equities and

INTO alternatives and fixed income. We have done A LOT of survey work on this with expert calls with

Towers Watson (2nd biggest pension fund consultant) and with U.S. pension now closer to “funded

status” (they went from 70% funded status beginning in 2013 to over 90% funded status in 2014), the

$18.8 trillion market is now immunizing with bonds and replacing equity exposure with alternatives.

Alternatives have 20% share currently but should grow to 30% of the U.S. pension system over the next

decade. This 1% market share growth per year IS A MASSIVE OPPORTUNITY at $180 BILLION IN INFLOW

PER YEAR. We like the 20 year track record at OZM to capture this opportunity and the fund has

substantial scale to handle new inflow. 1/3 of OZM’s client base is U.S. pensions so the relationships are

already established:

LEGG MASON (LM) also benefits from pension re-allocation and this leading bond fund manager has

repaired performance to capture pension net inflows. In addition, we think the struggles at leading fixed

income firm PIMCO under German insurer Allianz are well discounted and in repair and thus with a

strong dividend yield and very strong investment performance that ALV shares are a strong long

candidate.

Conversely, leading equity manager T Rowe Price has substantial institutional Large Cap exposure with

close to $70 billion in exposure and also a fund complex that is in outflow and has closed over 20% of its

AUM to new subscriptions. Thus TROW and JNS are shorts on reallocation OUT of the equity asset class.

Long CAPITAL ONE FINANCIAL (COF) as credit card loan growth is just picking up, one of the few

categories of domestic loan growth with an improvement in delinquencies. The Fed’s G-19 data has

accelerated sharply as of late with consumer revolving credit averaging 6.0% annualized growth over the

last 3 months (M/M annualized rates), up from 1% Y/Y growth over the past few years. Credit cards are

a FAST asset and are closely correlated to U.S. unemployment claims which continue to DECLINE year-

over-year. Capital One stock is also CHEAP with continued synergies from the cycle’s acquisitions of ING

DIRECT and HSBC portfolios.

LONG the M&A Advisors and SHORT the Institutional Trading Exposures. M&A is the only game in

town and we like blue chip advisors LAZARD (LAZ) and the newly public MOELIS (MC) as longs. M&A

activity is running at the highest level since 2007 with the new strategy of tax inversions likely leading to

a longer cycle.

LONG the HomeBuilders and the Mortgage Insurers. Generally, Pending Home Sales (PHS) leads

Home Price Indices (HPI) by 12 months, and HPI and the XHB homebuilder index are strongly

correlated. After a temporary slide in 2014 due to weather and some new credit restrictions (QM

rulesets), PHS is starting to positively inflect again on a year over year rate of change basis which

will pull HPI and thus housing equities up with it. In addition, the physical housing stock in the U.S.

generally has been underinvested in which should over time move 800,000 in current starts to

closer to 1.15 million on a seasonally adjusted basis which should power the home builders higher.

Both Beazer Homes (BZH) and KB Homes (KBH) are good candidates to invest in this trend with

low expectations. In addition BZH has had some insider buying recently which has historically

signaled a good entry point.

SHORTING Nationstar and Encore Capital. Nationstar Mortgage (NSM) in additional to being in

the worst sector wrought with regulatory risk and a declining forward transfer opportunity,

understates its amortization expense (with D&A costs under its CPR rate) and it also is not clear

what the company exactly makes in its servicing business. This makes it a good short candidate.

Encore Capital (ECPG), has just blown through all its tangible equity capital with a series of

acquisitions, levering the company at the wrong part of the cycle with acquisition IRRs well below

average.