A Comprehensive Quantitative Breakdown Of Citigroup: Expect More Upside
Citigroup has every quality you look for in a stock. Value, momentum, earnings quality, and qualitative catalysts.
The company has recently started beating analyst EPS and revenue estimates.
Short-term technical outlook is strong, indicating likely upside over the next few weeks. Now is a good time to invest.
Citigroup remains cheap due to the uncertainty regarding government oversight as well as fears of another recession.
We set a 12-month price target of $69.68 (representing an upside of 19%). The average Wall St. analyst has a price target of $65.64 (12% upside.).
Ever since Citigroup's (NYSE:C) fall from grace as the biggest bank in the world to having to be bailed out by the U.S. government, investors have been wary of the bank and its management. However, since then, Citibank has been selling off assets from Citi Holdings and is now one of the best-capitalized financial institutions in the world. Citi currently possesses many of the factors of stocks that have historically outperformed the market. The stock trades at a cheap valuation and yet has strong price momentum, which is a strong signal of future outperformance.
We'll remind investors that we are quants who sift through academic papers and historical data to find repeatable patterns that can be exploited for profit. We've distilled our insights into an equity-pricing model that seeks to use historical back testing to generate 12-month price targets that are more accurate than the Wall Street consensus.
The strongest bull argument about Citi regards its cheap valuation. Its clear from it's relative value profile why:
Earnings yield has historically been shown to have the highest correlation to excess returns, and is thus the most relevant metric to consider when highlighting a stock's value profile. At 7.31%, Citigroup's earnings yield is nearly twice the market median of 3.89%, ranking it in the 82nd percentile of all stocks in the market (NYSE and NASDAQ). Historically, stocks with an earnings yield ranked in the 80-89th percentile of the market generate annual excess returns of 4.06%:
Citigroup is also cheap from a price-to-book standpoint, as investors can currently buy the stock for only 82% of its book value. This places it in the top decile of all stocks from a book value basis, and makes it a safe investment for conservative value investors. While not exactly a free cash flow machine, Citigroup's free cash flow yield is well above the market median of 9.33% and offers further upside. Investor's won't be buying the stock for its meager 0.34% dividend yield, but now that the government has approved a $7.8 billion share buyback program and dividend increase to $0.05 per quarter, expect more capital to be returned to shareholders.
Our algorithms rank Citi's value profile in the 85th percentile of all stocks in the market (i.e. top 15%). Our algorithms expect its relative value profile to contribute 4.50% of alpha moving forward. This means that, holding everything else equal to zero, we expect Citi to outperform the market by 4.50% over next twelve months just based on its relatively cheap valuation.
The financial sector is the second highest performing sector over the last 6 months, behind only Health Care, with the average stock gaining 10.45% over that period (versus the market average of 3.02%). Citigroup has been a leader during this run, with a 6-month price performance that more than doubles its sector average. Below is Citigroup's growth overview:
The strongest two aspects of Citigroup's growth profile are its 6-month price performance of 22.68% and its 29.49% 12-month earnings growth. Investor sentiment has clearly shifted on the stock since its brutal 2014 Q4 (Jan 15, 2015) earnings release. In that quarter, Citi's EPS missed Wall St. consensus estimates by over 33%. Its year-over-year EPS growth rates are positive once again, and the market has rewarded its strong earnings. Citigroup's growth profile is hindered by its weak profitability on both an ROE and ROA perspective, and while this is a viable risk, management has taken a proactive approach in reducing the size of its underperforming assets. As a result, over the last 3 quarters, Citigroup's ROA has increased each quarter, rising from 0.39% to 0.70%. Its ROE has also increased each quarter, rising from 3.64% to 6.34%. This is clearly a favorable trend that seems likely to continue.
We rank Citi's growth profile in the 59th percentile of all stocks in the market. Our algorithms expect its relative growth profile to contribute 1.04% of alpha moving forward. This means that, holding everything else equal to zero, we would expect Citi to outperform the market by 1.04% over the next twelve months just based on its solid growth.
While oft ignored, the quality of a company's earnings is an important and predictive measure of a stock's future success. Investors are fixated on the short-term bottom line, and thus companies are priced based on the quantity, rather than the quality of their earnings. This leads to artificially high prices for companies with very poor quality earnings, and vice versa. With that in mind, we will consider Citigroup's earnings quality:
Firstly, it's important to consider that the correlations to excess returns for earnings quality are generated at the extremes. For example, even though Citigroup's earnings accruals ratio is only ranked in the 46th percentile of the market, it is still slightly positively correlated to excess returns. Earnings accruals ratio is a measure of the "non-cash" earnings reported. While non-cash earnings are not inherently bad, to an extent, really high levels (+6%) may be indicative of management attempting to "game" earnings for short-term gain. At 0.43%, a very small percentage of Citigroup's earnings are non-cash and there is little for investors to be wary of from this standpoint.
The financing to assets ratio of -1.11% shows that Citigroup is paying back debt and buying back shares, both of which should increase future earnings per share. Finally, its depreciation to capital expenditures (CAPEX) ratio of 145% shows that Citigroup's depreciation expense was much higher than its capital expenditures. This is a good sign as management is clearly not afraid to hurt its short-term earnings (depreciation is expensed, while CAPEX is capitalized) in order to have stronger future earnings.
Our algorithms rank Citi's quality profile in the 77th percentile of all stocks in the market. Our algorithms expect its relative quality profile to contribute 3.90% of alpha moving forward. This means that, holding everything else equal to zero, we would expect Citi to outperform the market by 3.90% over the next twelve months just based on its strong earnings quality.
While earnings momentum is not factored into our equity-pricing model, it can be used as a good supplementary indicator of a company's performance relative to analyst expectations. A look at Citigroup's earnings history shows a clear trend:
Citigroup has consistently underperformed Wall St. expectations for the fourth fiscal quarter (FQ4). This trend goes all the way back to 2009, when they missed by 3.03%. In fact, since that FQ4 miss in 2009, Citigroup has missed every FQ4 estimate while missing no other estimates, other than FQ3 2013. It appears that investors may not have noticed this trend and the price inevitably dips around every FQ4 report. It's also important to consider the year-over-year growth rates to try to discern company trends:
The good news is that over the past 2 quarters, EPS growth has been positive, hovering around 17%. In fact, other than the disastrous FQ4 of last year, Citigroup had been growing EPS fairly consistently. Revenue growth, on the other hand, has been consistently negative, hovering around -5%. This is a result of Citigroup becoming leaner and divesting the less efficient revenue streams, which is why EPS growth has been consistently positive. In all, it looks like Citigroup's earnings are trending positively and will likely beat its FQ3 2015 estimates (though, if history is any indication, it will likely miss its FQ4 estimates.)
While we'll keep this part short since Seeking Alpha is for longer-term investment ideas, it's important to consider the expected short-term price movements to determine whether now is a good time to take a position. With that said, below is Citi's technical overview:
Citi is trading well above its 20-day, 50-day, and 200-day moving averages, indicating strong short-term uptrend. This is important to watch, as academic studies have shown that stocks that trade above their moving averages tend to perform much stronger than the market over the following days and weeks. While the stock price is moderately overbought (gaining 5.6% over the last twenty days), the short-term return reversal effect only applies to illiquid stocks.
Citigroup is trading right near its 52-week highs. Again, this is a very bullish sign moving forward as stocks that trade near their highs have beenacademically proven to outperform over the subsequent months. Prospect theory states that people become risk-averse when holding profits. When a stock is at a 52-week high, the majority of investors holding the stock have a profit on the stock. This creates a strong behavioral urge to "lock in profits" for investors, leading to irrational selling pressure. Rational investors can exploit this phenomenon and generate excess returns by buying stocks when they are at 52-week high.
Overall, our short-term quantitative technical analysis model rates Citigroup's short-term outlook as "Strong". This means the stock is likely to outperform the market over the following 20 days. Keep in mind that technical analysis indicators tend to be less useful for low volatility stocks like Citigroup.
It's important to supplement quantitative analysis with a discussion of qualitative factors affecting the company. We don't advise investors to make decisions solely on the quantitative merits of a company without first considering its potential catalysts and risks. It's also important to try to create a "story" as to why a stock may be performing a certain way and how it will perform in the future. This makes it possible for you to compare your predictions to the stock's actual performance and constantly reevaluate the accuracy of your story to determine whether to stay in the position or not.
Firstly, we agree with Oakmark Fund's Bill Nygren (who manages over $16B in assets and owns 8.13 million shares of Citigroup) who states that Citi has "two hidden sources of value, neither of which is reflected in GAAP earnings: a deferred tax asset and a larger base of excess capital that is growing at a rapid rate." He says that these are assets that are likely undervalued by the market because of their hidden nature, and that their eventual recognition will likely lead to further price gains. We also agree with Mr. Nygren that last year's quantitative stress test confirmed that "the company has significantly more excess capital than its peers" and that this capital will eventually benefit shareholders through capital return or smart balance sheet growth. Another significant catalyst is the expected interest rate hikes (though the timing of these hikes is unknown) that should provide an earnings tailwind as the bank's net margins increase.
The risk factors to consider are further conduct and legal problems that could lead to future fines and spark investor fears. There's also the potential for further regulatory interventions such as increased liquidity requirements or higher regulatory capital demands (though Citi would be better positioned than its peers in this respect). Finally, there's the potential that interest rates take longer than expected to rise or that the global economic recovery changes course and a new depression takes place.
We feel that these risks are overblown and that potential catalysts far outweigh the risks regarding Citigroup. This qualitative analysis supports our quantitative findings.
Given its undervaluation, strong short-term momentum, earnings quality, and earnings momentum, we feel that Citigroup has an attractive quantitative profile that will outperform the market over the next 12 months.
Our equity pricing model uses historical back testing to predict the amount of "excess returns" (i.e. alpha) that a stock will generate. It combines this with the stock's beta to project a range of 12-month target prices. This range is expected to have a 75% area of accuracy (i.e. the stock price will be within the price range 75% of the time). These projections are shown below:
On our base case, the Quantified Alpha algorithms expect Citigroup to rise from its current price of $58.44 to $69.68 over the next twelve months. This represents upside of 19.23% from current prices.
Our algorithms project a 75% probability that Citigroup's stock price will be between $50.41 and $90.87 in 12 months. This ranges from potential downside of -13.75% to potential upside of +55.49%. Risk-reward looks skewed to the upside. These are more optimistic projections than Wall Street analysts, who currently have an average 12-month price target of $65.64 (representing upside of 12.32% from current prices).
We advise investors looking to take advantage of this opportunity to look at Citi's long-term options, specifically the March 20th, 2016 $55 calls. They are currently trading for $6.15, which implies a break-even price of $61.15 ($55 + $6.15). This means that investors need only a 5% move in Citi's stock price from now until March 20th (8 months) to break even. While it's generally smart to avoid buying options (75% of options expire worthless), long-dated in-the-money options are typically cheap and offer investors the benefits of leverage without the "theta burn" of short-term options.
Overall, we feel that Citi is a great long-term opportunity in an otherwise expensive stock market. We have analyzed every quantitative factor that has historically been shown to have predictive value, and they all mostly indicate future outperformance for Citi. While the past doesn't repeat itself, it does rhyme. Investors would be wise to learn from the lessons of the past, and take advantage of this rare opportunity.
