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Here's some information I'd like to present to you that I hope you put in the "history may not repeat, but it sure does rhyme" file in your brain. During the bubble years of the 1920s, railroad stocks were all the rage with investors. They were posting record profits. They had a reputation for reliable dividends. They were trading at lofty valuations. They were the cornerstones of every Main Street investor's portfolio. And then, the Great Depression happened. Earnings collapsed. Dividends got cut. Valuations fell to crippling lows. Railroads became the most hated sector in the economy, with many investors swearing "never again" due to the betrayal of the dividend cuts at the onset of the Great Depression.

And then, of course, railroad earnings recovered and boomed, dividends grew, and the railroad sector went on a 25-five year bull market, with 18 out of the 25 largest railroad companies in America beating the Dow Jones from 1938-1963. Sound familiar?

During the bubble years of the 2000s, bank stocks were all the rage with investors. They were posting record profits. They had developed a reputation for growing dividends. They were trading at high valuations. The growing dividends at Citigroup (C), Wells Fargo (WFC), US Bancorp (USB), Bank of America (BAC), and JP Morgan (JPM) were alluring to many investors. And then, the financial crisis happened. Earnings collapsed. Dividends got cut. Valuations fell to crippling lows. Bank stocks became the most hated sector in the economy, with many investors swearing "never again" after experiencing the dividend cuts of 2008 and 2009. Of course, we have a couple decades until we can look back with hindsight to see whether the early 2010s marked the onset of an extended bull market in bank stocks.

And to be sure, there are two things unique to bank stocks that do not apply to railroads:

1. Bank stocks cannot tolerate a lot of abuse from management. In the 20th century, it was hard for a manager to screw up a railroad company. It would be like trying to run a firm like Pepsi (PEP) or Kraft (KRFT) into bankruptcy. Sure, it could theoretically be done, but it would take almost deliberately bad management to mess up one of those companies. A greedy railroad CEO does not pose nearly as big of risk to shareholders as a greedy bank CEO. If you contemplate a bank investment, you need to evaluate the risk that a management team may or may not pose to your investment with a clear-eyed scrutiny.

Just think of Bank of America's acquisition of Countrywide during the financial crisis. That was probably the worst acquisition of any company that I've seen in my lifetime. It almost took down the legendary bank that had spent the previous century developing a reputation for its conservative banking practices. If you own a bank where the CEO wants to recklessly build an empire, you can undo a century's worth of work in a few short years. That kind of risk simply didn't apply to the railroad stocks in the analogy above.

2. Bank stocks have a tendency to experience a severe financial crisis every 25 years or so. No one wants to spend two decades acquiring shares in an excellent bank, dutifully reinvesting dividends and making additional purchases when warranted by an attractive valuation, only to watch all your capital get destroyed. Imagine being a long-term shareholder in something like Wachovia, a bank that was excellent and conservative…until it failed and wiped out 90% of shareholder's equity.

But nevertheless, we have found ourselves in a situation where bank stocks may present an interesting opportunity for an investor seeking gains in both capital appreciation and future dividend income. Although bank stocks have enjoyed a recent run-up, many are still cheap on a book value basis, and many are paying out dividends well below their long-term target levels. For instance, Wells Fargo will be paying out roughly a third of its earnings as dividends this year. Its long-term target is to pay out about 60% of earnings as dividends. US Bancorp had its dividend sharply cut during the crisis, and the company has been awarding investors healthy dividend increases as it slowly crawls back to a normalized payout ratio level. And Bank of America, still paying investors a penny per share in dividends, has been retaining capital by Fed mandate to pass the stress tests, and could grant investors a significant boost in capital gains when the announcement of a dividend increase does arrive.

The dilemma for a conservative income investor is this: How should you reconcile the likelihood that most large-cap banks (Citigroup potentially being a major exception) will grant investors meaningful dividend increases over the next five years with the fact that the banking sector as a whole has a nasty tendency to explode every generation or so (thus posing a risk to owners with very long-term orientations)?

Here's how I answer that question. First of all, the fact that even Wells Fargo and US Bancorp could not maintain their dividends during the financial crisis tells us that nothing is sacred when it comes to the financial sector (even though Wells Fargo was healthy enough to maintain its dividend until the Fed ordered a cut). The fact that those two conservatively managed banks had to cut their dividends during the crisis leads me to this inevitable conclusion: if you have permanent capital that you cannot afford to lose, then you should not own banking stocks period. The fact that even the best-in-breed bank stocks had to cut their dividends is enough proof that you should avoid putting yourself in the position of having to rely on dividend income from banks.

However, if you are a conservative investor who has surplus capital that you are willing to lose while pursuing a reasonable chance of capital and income gains over the medium term, then bank stocks may be an appropriate investment. In particular, I'd be waiting for a 10% haircut from Wells Fargo and US Bancorp. These two banks are best in class, and are poised to both grow earnings and raise the payout ratio meaningfully over the next five years, making them potentially lucrative investments for conservative income investors.

Source: The Role Of Banks In A Conservative Income Portfolio