When I consider investing, I usually look at sectors, then at individual stocks. And I have a great temptation to pick those lagging in hot sectors, because a rising tide lifts all boats.
Right now, banking is a hot sector. While big banks have been behind the curve, there is evidence that they're now catching up. The huge profits announced this year have continued into the third quarter. Bank of America (NYSE:BAC) made $2.5 billion. Citigroup (NYSE:C) made $3.2 billion and called it disappointing. Goldman Sachs (NYSE:GS) made $1.52 billion, Morgan Stanley (NYSE:MS) made $1 billion.
Of the biggest banks, only JPMorgan Chase (NYSE:JPM) managed to lose money, $400 million, as it continued to suffer from government litigation involving the London Whale, the 2008 market collapse, and the mortgage fiasco leading up to it.
The usual way to catch this rising wave is to focus on the companies behind the curve. I define the curve in banking as a company's price relative to its book value. If a bank's assets aren't worth what it claims they are, that should be an opportunity in normal times.
Here is where you would be wrong. Since the collapse in stocks peaked in mid-November of 2008, Goldman Sachs has had the best performance, up 137%. Wells Fargo (NYSE:WFC) is up 45% - both sell at a significant premium over their book value.
Morgan Stanley and JPMorgan Chase, which both trade near their book values, are also up, with Morgan Stanley's gains close to those of Goldman Sachs and JPMorgan Chase's on par with those of Wells Fargo.
But those companies trading at a significant discount to book, Bank of America and Citigroup, have not made up ground. Bank of America is still down from its late-2008 valuation, and Citigroup is still worth half what it was, after adjusting for its reverse stock split in 2009.
The point is, banking is profitable, and if you can concentrate on banking you can make a lot of money. I look at book value as a sort of "Mendoza Line" for the sector, after the Pittsburgh shortstop who enjoyed a 10-year major league career despite hitting just .200. If you can get near that line, and stay out of trouble, you're a buy in this environment.
Thus, an earlier call I made on Bank of America, based on its low price to book, was probably in error, even going forward. The best bet in the sector should be Goldman Sachs, although I prefer Wells Fargo because it's a "real" bank, not a trading company turned into a bank by regulators. Other regional banks trading at a solid premium to book value, and worth buying, are US Bank (NYSE:USB) (up 41%), Capital One (NYSE:COF) (up 130%) and Prosperity Bancshares (NYSE:PB), which has more than doubled in value thanks in large part to the high-quality assets brought up by Texas's oil boom.
So to summarize my rules for bank investing, after this research, look for an absence of legal troubles, and a good premium over book value, or at least something close to it, in order to get the best returns from the coming bank boom. Just because investors have intuited all this doesn't make them wrong.
Rather than just buying what I say to buy, do your own research. Look at the bank stocks in your own region, and remember that for the next few years banking should be a very good business to be in.
Disclosure: I am long PB, BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.