The MarketGrader Indexes turned in another solid showing in 2011, particularly considering the market’s continued uncertainty and resulting volatility. Among all indexes the year’s best performer was the MarketGrader Health Care Index, which was up 17.18% in 2011, comparing very favorably to its benchmark, the Dow Jones US Health Care Index, up 9.44%. Since 2002 MG Health Care has had only one down year, when it lost 26.08% in 2008. This is reflected in its 3 and 5-year annualized returns of 17.13% and 5.45%, besting the benchmark’s 10.20% and 1.59% respectively. For our readers that aren’t MarketGrader.com subscribers yet, you may view the current components of the MarketGrader Health Care Index by clicking here. For all other index components, including the Barron’s 400, please take a free trial.

Two other notable performances among our sector indexes were attributed to the MarketGrader Consumer Staples Index, up 12.96% in the year and the MarketGrader Financials Index, up 2.30%. The latter might not seem like much but it’s impressive considering its benchmark, the Dow Jones US Financials Index lost 14.62% in 2011. MG Financials now sports a 3-year annualized return of 10.46% and a 5-year return of -6.41%, which of course includes 2007 and 2008 when it lost 17.77% and 35.22% respectively. The Dow Jones US Financials Index is up only 2.66% per year in the last three years and down 16.20% on a 5-year annualized basis, a full 10 percentage points below our index. In the case of our Consumer Staples Index its 3 and 5-year annualized returns are 18.70% and 5.00%, handily beating the Dow Jones US Consumer Goods Index, with annualized returns of 13.91% and 2.78% respectively in the equivalent periods.

The Barron’s 400 Index had a flat year, actually ending 2011 down 0.41%, essentially in line with the S&P 500. However, its 3-year annualized return, now that 2008 has fallen off the back of the calculation, is an impressive 19.30% compared to the S&P 500’s 11.66%. Who said money can’t be made in stocks anymore? On a 5-year basis, the Barron’s 400 is up 1.38% per annum, besting the S&P’s -2.38%. Among our Core indexes, who share the Barron’s 400 methodology, last year’s best performer was the MarketGrader 100 Index, up 1.83% for the year and 19.45% annually since 2009. It is worth noting that MG 100, MG 200 and the Barron’s 400 all beat the mutual fund Multi-Cap Core average in 2011 and certainly on a 3 and-5 year annualized basis. Active managers in the category lost, on average, 2.29% in 2011 while still being up 13.86% per year, on average, since 2009. This is an underperformance of almost 550 basis points relative to the Barron’s 400.

A stellar performance worthy of a stand-alone mention was turned in by the MarketGrader Mid-Cap 100 Index, which gained an impressive 8.77% in 2011, beating by a mile the S&P 400, which lost 3.01% and the average of all mutual funds in the mid-cap category, who collectively lost 3.57%. In the last three years the MarketGrader Mid Cap 100 is up an astounding 24.09% per year, compared to 17.77% and 16.95% for the two aforementioned benchmarks.

A thorough analysis of our performance last year isn’t complete without a mention of our laggards. Among them was the MarketGrader Small Cap 100 Index, which lost 3.22% while the S&P 600 Index lost 0.16%. If it’s any consolation (and it’s not,) the loss wasn’t as bad as the 3.75% average decline of all U.S. mutual funds in the small cap category. Among our sector indexes the MarketGrader Consumer Discretionary Index lost 0.22% while the Dow Jones US Consumer Services Index gained 5.50% and the MarketGrader Energy Index lost 3.81% while the Dow Jones US Oil & Gas Index gained 2.32%. In both cases the MarketGrader indexes are still beating their benchmarks on a 3 and 5-year basis.

The year’s worst underperformer was the MarketGrader Technology Index, which fell 10.50% compared to the Dow Jones US Technology Index’s loss of 0.83% and the tech-heavy NASDAQ Composite’s decline of 1.80%. However, MG Technology is still solidly in the black on a 3 and 5-year basis, up 20.14% and 4.20% per annum respectively.

Please click here for our complete 2011 MG Indexes Report Card. Happy investing in the New Year.

Major bank stocks in the U.S. and Europe fell on Wednesday following Moody’s downgrade of Citigroup, Wells Fargo and Bank of America and the FOMC’s announcement of further monetary stimulus measures in the face of a worsening economic outlook. Financials in general fell again yesterday in sync with a global equity sell-off. Investors rightfully fear that in addition to an already-difficult operating environment bank profitability will suffer as a consequence of the Fed’s new ‘operation twist,’ which seeks to flatten the U.S. yield curve by switching its mix of treasury securities increasingly towards longer dated maturities. Additionally the Fed will reinvest the principal it receives from maturing mortgage bonds into additional mortgage securities in hopes of lowering mortgage rates even further below its current historical lows. While it hopes to boost investment and consumption with these moves, the Fed’s actions could also put pressure on bank profitability by squeezing the margin between the short term rates at which they borrow and the longer term rates at which they lend. In addition to this, much uncertainty remains among banks regarding Dodd-Frank rules still being implemented by regulators.

Ongoing bank weakness in the United States is still evident in industry-wide metrics followed by MarketGrader.com, such as average return on assets, currently at 0.43% and a still elevated solvency ratio of 55.6%, which represents banks’ non-performing assets as a percentage of tangible equity plus loan loss reserves. However, despite all the work still ahead for the banking industry in the United States, many banks today are in much better shape than they were three years ago in the throes of the financial crisis as a result of the actions they’ve undertaken during this period. Such actions are beginning to separate a few banks from the pack, putting them in a favorable position to gain market share and rebound strongly when the U.S. economy returns to a path of higher growth. The following three banks are, based on MarketGrader.com’s analysis, the best three major banks in the United States today (JP Morgan Chase, which is highly graded by MarketGrader.com, has been excluded from the report since its business encompasses much more than traditional commercial banking, including wealth management, capital markets and investment banking.)

1. PNC Financial Services Group Inc. (NYSE: PNC)

The highest rated Major Bank in MarketGrader.com, with a grade of 72.4, is Pittsburgh-based PNC Financial Services Group, with $263 billion in assets and a market capitalization of $25.1 billion. Its revenue last quarter fell 10% from a year earlier, mostly attributed to a softening of economic conditions in the U.S., at least from our perspective in which overall bank results reported last quarter seemed to decelerate from higher growth rates in the preceding two years. More importantly, PNC’s trailing 12-month revenue of $16.57 billion was 59% higher than the equivalent period ended three years ago, in the middle of the financial crisis. The bank’s quarterly revenue is now running at an approximate clip of $4 to $4.4 billion, well above the September 2008 trough of $2.3 billion. Trailing 12-month net income is up 150% also in the last three years; naturally a dividend increase has followed these improved results after PNC hiked its payout earlier this year from $0.35 per share from the $0.10 per share to which it had been reduced in 2009 as the company was shoring up its capital base. Still, today’s payout is only a little more than half its pre-crisis payout of $0.66 per share, though the stock yields an attractive 2.9%. The bank’s after-tax payout ratio, on a trailing 12-month basis, is still a very manageable 12.9%.

While the bank’s net interest margin fell last quarter to 4.85% from last year’s 5.18%, the ratio is still solidly ahead of the 4.47% bank average. Net interest margin represents net interest income as a percentage of interest earnings assets. During the 12 months ended last quarter PNC’s return on equity improved to 10.2% from a year earlier while return on assets came in at 1.28%, well ahead the 0.43% industry average calculated by MarketGrader.com. Closely followed capitalization metrics have been improving significantly in recent quarters too. While non-performing assets now account for a still-elevated 20.4% of tangible equity plus loan loss reserves, this ratio fell from 33.2% a year ago, a vast improvement. The bank’s tangible equity ratio, which measures tangible common equity as a percentage of total tangible assets, is very solid at 8.6%. However, one area of concern worth watching closely in coming quarters is PNC’s loan loss reserves level. Today the bank has only $0.06 in loss reserves for every dollar in non-performing assets, a 33% decline from $0.09 a year ago. The bank’s current levels of capital have come at a steep price particularly for long-term holders of the common stock. Today PNC has 50% more common shares outstanding than it did at the end of 2008, right before it started its drive to raise capital. But for new shareholders what matters now is what the bank does with its capital going forward and whether it can capture market share from weaker rivals.

In addition to such adequate capitalization levels, the bank’s operations seem well positioned to absorb the impact that the Fed’s upcoming operations may have on the bank’s profitability. Its total interest expense last quarter represented only 15.6% of total interest income, well below the 43% bank average. The bank currently generates revenue of $0.38 and net income of $0.07 per employee in a 12-month period compared to the averages for Major Banks of $0.30 and $0.01 respectively.

PNC shares look inexpensive, trading at seven times trailing earnings per share and 7.6 times forward full year estimates. At yesterday’s close of $46.74, 28% below the stock’s 52-week high, it is trading also at only three quarters of its book value or 1.16 times tangible book. Yet the bank has $41.06 in tangible equity per share compared to the average bank, which is only $12.67 per share.

MarketGrader.com Overall Grade: 72.4 (Buy)

MarketGrader.com Sentiment Score: 4.1 (Neutral)

2. Wells Fargo & Co. (NYSE: WFC)

MarketGrader.com’s analysis of Wells Fargo reveals a story not unlike that of PNC, illustrated above, but on a much larger scale considering the bank had $1.25 trillion in assets last quarter. While the bank’s growth was anemic in the last year as the U.S. economy slowed down, its overall financial picture is a lot different than it was in 2008. WFC’s revenue fell last quarter by 5% compared to the year-earlier period while, more importantly, trailing 12-month sales of $90.87 billion were 64% higher than the equivalent period ended in mid-2008. The bank did, of course, absorb all of Wachovia during this period, which accounted for a significant portion of this growth. Based on recent results it’s clear management has been very successful in integrating both bank’s operations profitably and efficiently. While the bank’s net income jumped 29% last quarter from Q2 2010, it increased almost 96% in a three-year period for the 12 months ended in June to $14.46 billion. This allowed the bank to increase its dividend earlier this year to $0.12 per share from $0.05 per share. While this will translate, on a full-year basis, into a 70% increase, it is still well below the bank’s pre-crisis payout of $0.34 per share.

Wednesday’s downgrade of the bank’s debt by Moody’s was, in large part, attributed by the rating agency to its perception that the U.S. government could indeed let a major bank fail should it run into trouble again, which we doubt. Call this the end of the ‘Geithner Put’ if you will, the fact is that Wells Fargo today finds itself in a very different capital position than in 2008-09. In this time frame its tangible common equity has increased almost six-fold to $73.89 billion from a low of $12.51 billion in the third quarter of 2008 while in the same period assets have only increased by a factor of two, including the addition of Wachovia. This translates into a tangible equity ratio of 6.11%. While better than last year’s 5.57%, the ratio is still too low and investors should look for it to continue climbing, especially considering the bank’s non-performing assets account for 34.7% of its tangible equity plus reserves for loan and asset losses. This is significantly better than the 55.6% bank average and more importantly, lower than the 38.3% reported a year ago last quarter. Clearly the bank still has a lot of work to do, particularly with regards to its capitalization and especially if mortgage loans across the country continue to sour. WFC has today $0.07 in loan loss reserves for every $1 in non-performing assets, half of what it had a year ago and a dangerously low level, particularly if housing prices continue to fall and economic indicators continue to worsen. The bank, however, has done much to shore up its capital base in the last three years. Today it has 60% more common shares outstanding than it had in the summer of 2008, right before Lehman’s collapse. Further dilution of existing shareholders on such a scale, while unlikely, seems like the highest risk for investors in the company’s shares. This makes the company’s ability to continue operating profitably and cover potential losses with earnings from operations over the next 12 to 18 months something investors should follow closely. Fortunately, on the profitability front, the bank’s indicators seem to be pointing in the right direction.

Wells Fargo reported operating results last quarter that translated into a net interest margin of 4.75%, which, although lower than last year’s 5.07%, is still indicative of solid profitability in its core operations and well ahead of the 4.47% bank average. Its trailing 12-month results translate also into a return on equity of 11% and return on assets of 1.16%. In contrast, Bank of America’s return on equity and return on assets over the last four quarters were negative while Citigroup’s were 5.6% and 0.5% respectively. JPMorgan Chase, which we also rate ‘Buy,’ reported last quarter a trailing 12-month return on equity of 10.6% and return on assets of 0.91%. Worth mentioning too, based on Wells Fargo’s latest quarterly results, is the fact that its total interest expense accounted for only 13.8% of total interest income, giving it ample room to continue operating profitably in a flat yield curve environment. The bank generates $0.34 in revenue and $0.05 in net income per employee, well above the industry average for both.

The bank’s shares, trading barely above their 52-week low, are currently valued at only nine and seven times 12-month trailing and forward earnings per share respectively. They trade also at book value or 1.7 tangible book and 1.4 times sales. With a 2% dividend yield, at current levels investors get paid almost 30 basis points more than they would lending to the U.S. Treasury at 10 year rates, while they wait for the dust to settle and the U.S. economy to resume growing at a normal rate (2.5% to 4%,) which undoubtedly it will. When it does Wells Fargo seems well positioned to rebound nicely along with it.

MarketGrader.com Overall Grade: 68.4 (Buy)

MarketGrader.com Sentiment Score: 4.4 (Neutral)

3. U.S. Bancorp (NYSE: USB)

Minneapolis-based U.S. Bancorp had $308 billion in assets last quarter, slightly above PNC’s $262 billion and only a quarter of WFC’s $1.25 trillion. The bank has a market capitalization of $44 billion.

While its net income jumped 36% last quarter to $1.2 billion, its revenue was almost flat at $5.27 billion relative to the year-earlier period. It has taken the bank a full three years to return to its pre-Lehman revenue and net income levels, underscoring the impact that the financial crisis had on its business. USB’s trailing 12-month revenue and net income of $20.89 billion and $4.11 billion respectively are virtually unchanged from the 12 months ended in June 2008. However, its capital base is vastly improved.

USB’s $17.63 billion in tangible equity represents 5.71% of its tangible assets, an improvement from 5.5% a year ago and an adequate level of capital. In contrast, its tangible equity ratio at the end of 2008 was 3.0%. Its non-performing assets fell significantly last quarter relative to its tangible equity plus its reserves for loan and asset losses to 28.3% from 45.5% a year ago. However, so have its reserves, which last quarter accounted for 11% of non-performing assets compared to 14% a year ago. This doesn’t necessarily translate into an erosion of the bank’s loss reserves but could mean, instead, that management thinks the worst in asset write-downs is behind them rather than ahead. Nevertheless, further deterioration of the bank’s balance sheet could force it to put aside in reserves more than anticipated if current levels of profitability cannot be sustained in a deteriorating economic environment.

Last quarter USB recorded a healthy 4.79% net interest margin, albeit lower than last year’s 5.2%, with interest expenses accounting for 20% of interest income, trademarks both of an efficient operation. On a trailing 12-month basis the bank’s return on equity was a very solid 13.4% while its return on assets was also a strong 1.34%. USB generates $0.32 in revenue and $0.06 in net income per employee, both well above the Major Bank industry average.

The bank’s shares, trading 20% below their 52-week high, yield 2.2%, based on a per share payout of $0.125, more than double the payout of the last two years but well below the $0.425 it used to pay in 2008. The stock is valued at 11 times trailing earnings per share and 8.8 times next year’s consensus estimate. It trades also at 1.5 times book or 2.5 times tangible book value. With only 10.9% more common shares outstanding than it had in June 2008, USB has diluted its equity base the least among the large banks that were recapitalized following the financial crisis. This speaks volumes of management’s regard for its shareholders.

MarketGrader.com Overall Grade: 61.7 (Buy)

MarketGrader.com Sentiment Score: 6.2 (Neutral)

Following the Federal Reserve’s announcement last Friday that some banks may be held to higher capital requirements that correspond with the bank’s importance to the financial system (MarketWatch), investors have been bearish on financial stocks, especially large cap banks. The impact of this announcement is evident in companies such as Citigroup (C), which dropped 4.5% on the trading day after this announcement.

Year to date the S&P 500 Financial Index, which underlies the popular XLF ETF is down 6.6% while MG Financials is up 2.5% in the same period. These are price-only returns of the indexes and exclude dividends or the costs of owning a fund or ETF. Over a longer period of time, MG Financials’ out performance is even more remarkable. Based on three-year price only cumulative returns, as of yesterday’s close, MG Financials has outperformed the S&P 500 Financials Index by more than 38 percentage points.

3-Year Price-Only Cumulative Returns:

MarketGrader Financials Index:   +2.53%

S&P 500 Financials Index:    -35.89%

While some of this performance can be attributed to the fact that MG Financials is equally weighted, and thus not overly exposed to the mega-cap banks that crashed during the 2008 financial crisis, a good deal of the performance is also owed to sound stock selection and a disciplined rebalance approach. A few examples of its constituents appear below.

How is the index constructed?

The MG Financials Index consists of the 40 highest rated financial stocks (based on fundamental analysis) on MarketGrader.com and is rebalanced quarterly, with the last shuffle having taken place at the end of May.

As of June 7, 2011, the 3 highest rated stocks on the MG Financial Index were:

Anally Capital Management (NLY)- rated 84.4/100

Chimera Investment Group (CIM)- rated 81.9/100

Ares Capital (ARCC)- rated 80/100

The 3 stocks in the index with the largest YTD gains are:

Encore Capital (ECPG)- up 37.87%

Cash America International (CSH)- up 34.23%

Credit Acceptance Corp (CACC)- up 21.91%

When using ETFGrader to compare the MG Financials to an ETF that tracks the returns of the S&P 500 Financial Index, such as SPDR Financial Select Fund (XLF) we can see how these gains are possible. The MG Financial Index has an average rating of 68.23, whereas XLF has an average rating of 52.9. This reflects the fact that the MarketGrader Index consists of fundamentally stronger companies, which is reflected in the returns of the two indexes.