The investing herd can be quite curious. Investors tend to slowly react to major trends, and then get in a rush to embrace that trend because of timeliness. 

I’ve been thinking about the herd, and why it simply fails to respond to all of the major progress being made by Citigroup (NYSE: C), which remains my top financial services stock pick.

#-ad_banner-#I added Citigroup to my $100,000 Real-Money Portfolio in early February and I boosted my position by 33% nearly two months ago.

Frankly, if this wasn’t already such a big part of my portfolio, then I’d be adding more right now. 

I’ve been poring over Citi’s second-quarter results and they underscore the point that I’ve been naming for a while: This bank is a lot healthier than it’s very weak stock price might suggest. 

Blame it on the herd. It’s still getting over the bank’s recent troubled past. But one of these quarters, perhaps the next one or the one after that, Citigroup could deliver another solid quarter — and the herd could finally jump on board.

Getting healthier
Investors need to track two issues with this stock. The first is the state of the bank’s core operations (“Good Citi”). The second issue is how far along Citigroup is in the process of unwinding its exposure to the legacy parts of the business (“Bad Citi”) it no longer wants. 

On both counts, the news is quite good — especially in the context of a still-weak global economy. 

Make no mistake, Citigroup’s core operations are nowhere near peak performance. The major global economies are just too weak. But in the last quarter, Citigroup still managed to boost its deposit base by 6% from a year ago. And the bank’s loan portfolio is now 10% larger. Notably, loan scrutiny is much sharper than it was five years ago, so loan growth these days doesn’t imply the next round of loan blow-ups. That’s why Citigroup’s loan loss reserves keep shrinking. 

Rising lending and deposits, coupled with better-performing loans, enabled Citigroup to earn $1 a share in the second quarter, roughly a dime ahead of forecasts. Shares moved up modestly in an otherwise down market on Monday, July 16, but they’re still far too cheap.

Shares have been in the penalty box for the past few years, because a series of assets that were either performing poorly or no longer part of the lone-term plan was hindering the bank. These holdings (“Bad Citi”) included retail partner credit cards, CitiMortgage, private student lending, brokerage and a group of pooled assets. 

Three years ago, these assets accounted for more than 25% of Citigroup’s total asset base. Yet management has made good progress, and according to just-released data, these assets and deposits are roughly 25% lower than a year ago thanks to a steady stream of sales. 

They now account for just 10% of the total business. In effect, a key overhang for this stock is melting away. Still, “Bad Citi” bled away another $900 million in losses this quarter, blunting the core profitability of “Good Citi.” Much of that drag may finally be gone by this time next year.

Dividend or buyback
Thanks to rising profits, Citigroup is on track to boost its Tier One Capital above 8.0% in coming months, which is a key threshold for regulators. After being rebuffed earlier this year, Citigroup CEO Vikram Pandit is widely expected to revisit regulators in hopes of instilling a hefty dividend now that Citi’s balance sheet is even stronger. 

That’s the wrong move. Instead, he should be authorizing a major stock buyback program. This is because shares trade for just 44% of book value and just 52% of tangible book value. Any time you see such a discount, buybacks should be the only choice. The ability to shrink the share count quickly now leads to even higher earnings per share (EPS) down the road.

Round numbers
It’s hard to pinpoint how Citigroup’s results will look as the economy finally improves, but we can speak in rough terms. Right now, in a tough economy, Citigroup is capable of EPS around $4. In a slightly better economy (and with fewer drags from “Bad Citi”), EPS should reach $5, which correlates with the high end of the 2013 consensus profit range. In a stronger economy, EPS can handily exceed $6. Note that book value rises in tandem with profits (save for the profits applied to buybacks and dividends), so there’s a good chance that Citigroup’s tangible book value can approach $60 in a few years (that’s 85% higher than the stock price alone). 

And that’s precisely where I see this stock headed. Once the economy is firmer, investors will likely bid up banking stocks to at least tangible book value — if not above book value. I have no doubt that Citigroup will step on a few landmines along the way, but it’s increasingly clear that Citigroup is getting healthy — and the stock doesn’t deserve to stay so far below tangible book value. 

Risks to Consider: Have we seen the last of the European economic crisis? Probably not, and a revisit to the scary headlines may keep shares from going up.

Action to Take –> You need to separate a company from its stock. Citigroup’s stock still looks quite tarnished. But the bank’s operations are getting leaner and stronger. Pandit deserves high marks for righting the ship, and soon enough the herd of investors will respond.