Citigroup: Great Speculation for Five Years (No Idea After That)

Citigroup (C) lost $64.20 per share in 2008. Its Tier 1 Capital Ratio sank below 5%, and it had a portfolio worth hundreds of billions of dollars in loans that it did not originally underwrite that were lent out to people that were terrible risk-adjusted customers over the full course of the business cycle because they would stop payments during the downturn and never pay again. And the commercial loan portfolio wasn’t much better. Large depositors got spooked about the rumors of these non-payments, and started switching their global banking activities to firms on sturdier ground like The Northern Trust. The bank received an immediate $25 billion in taxpayer funds, and then engaged in the disastrous act of quadrupling the share count to stay alive–amputating two legs and two arms to stay alive.

I mention all of this to say that I fully understand the legitimate condemnation that has surrounded this company for the past five years. But I also understand that some of the best investment opportunities exist when the perception of a company is much worse than the underlying reality indicates. It is going to make $16.3 billion per year in net profit. That is after paying legal expenses. That is after paying taxes. That is after paying every single investment broker on the company’s rolls. That is after paying rent for the swanky 28-story office in New York. That is after counting the loan defaults. That is after counting the costs of compliance with Basel III and all other industry regulations.

To get an idea of how extraordinary that profit figure is, keep in mind that Coca-Cola is ubiquitous in 210 countries and still falls just shy of $10 billion in annual profits. Coke is the gold standard of multinational global behemoths, and Citigroup is going to make 1.63x as much money this year. It has a $629 billion loan portfolio, and that explains how a company can quickly emerge from the pits of despair into becoming more profitable than a soda conglomerate with over 500 drink offerings in 100,000 cities.

Citigroup has pruned $150 billion of subprime loans from its balance sheet since 2008, and now has a Tier 1 Capital Ratio of 11.6% (which is almost triple the capital ratio of 4.6% that Citigroup had on the eve of the financial crisis.) Because the dividend payment has been negligible, the company has bolstered its balance sheet by keeping over 97% of its profits since 2010.

Every year between 2010 and 2014, Citigroup made between $7 and $13 billion in annual profits. The quarterly dividend was a penny, and only got hiked to $0.05 recently. Nearly all of that money went to shore up the balance sheet.

Even though Citigroup was disastrous during the financial crisis, I have to analyze the company as it is today. It has triple the liquidity it had during the summer of 2008. The legal expenses are finally becoming a rounding error. It is only paying out $0.20 in annual dividends against $5.40 per share in profits, making it highly likely that shareholders will see nice dividend growth in the next few years ahead. Loan default rates are at ten-year lows. The credit quality, which still lags U.S. Bancorp and Wells Fargo, is far better than where it has been. If U.S. Bancorp is the Toronto Blue Jays and Wells Fargo is the New York Mets, Citigroup has grown from the Miami Marlins into the Houston Astros. Still work to do, but much better than where it’s been.

Citigroup strikes me as a candidate for medium term, but not long term, investing. A long-term investment is something where you can check out the earnings quality, figure out a fair price, buy it, and then say see ya and leave it alone for twenty years. You can do that with Hershey. You can do that with Colgate-Palmolive. You can do that with ExxonMobil. You cannot do that with many financial institutions in general, and you especially cannot do that with Citigroup in particular.

A medium-term speculation/quasi-investment, on the other hand, involves a five-year forecast in which you are thinking about earnings growth and catalysts that will cause the P/E ratio/valuation to rise. It’s a different animal. With Citigroup, the earnings growth advantage is rising interest rates. Just as REIT investors have made a killing over the past five years as borrowing costs have been especially low, soon banks will go back to making record profits without much effort once we enter a world in which the thirty-year Treasury rate enters the 5% range.

When that happens, Citigroup’s current engine will see profits rise from the $16 billion range to the $24-$28 billion range. It’s similar to the concept that brought Warren Buffett into Bank of America in 2011: buy at an undervalued price once the certainty of post-financial crisis survival is guaranteed but the fog of litigation expenses remains, and then hold through a period of rising interest rates when the bank profits rise somewhat effortlessly. The profit growth may be effortless, but it requires a multi-year time horizon and an ability to see underlying reality instead of the headline risk–this is a skill that many people lack.

Between 2015 and 2020, I think Citigroup has a high chance of beating the S&P 500. There likely be substantial dividend growth, due to the gap between the artificially low $0.20 annual payout and the $5+ in annual profits, and this combination of dividend growth, rising interest rates, and a few quarters of “clear history” without substantial litigation expenses will likely be the catalyst for an improving valuation. If you own a diverse collection of assets and are looking for something to do with 2% of your portfolio, Citigroup may make sense.

If you are looking for a generational investment, or are putting down the initial bricks of portfolio construction, Citigroup is not the stock for you. These kinds of people should be looking at Johnson & Johnson at $95 or Coca-Cola at $41. Even Hershey in the low $90s. But you do not base your retirement on the success of a bank with few lifetime employees and a default rate that is still the worst among the megabanks. You don’t want 20% of your wealth in Citigroup in the event that another unexpected, nasty recession takes hold.

People in the financial community always ask: “What’s your goal?” when someone discusses their investments. You hear it so often that it is easy to put up a mental block and ignore it. But how you answer that question determines the most appropriate investment selection. If you are looking for the maulers of your portfolio–you should look to the Master List of Stocks. But if you have 25 stocks and are looking for an ancillary holding to give you above market returns for the next few years, then Citigroup is a plausible candidate for consideration.