Regional Banks Might Be Undervalued

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Includes: IAT, KRE
by: Todd Feldman

Summary

Banks have been trading at a price to book ratio of one since the financial crisis.

We analyze the historical price to book ratio for banks and the financial sector since 1998.

We find that the regional banks appear to be undervalued relative to the larger financial services sector.

Since the 2008-2009 financial crisis, banks have been trading around 100% of book value. From 1999 to 2000, banks traded around 322% of book value. The overall US stock market trades at an average price to book of 2.58. Traditionally, value investors search for companies with a price to book below 2. On the surface, it appears if banking stocks are undervalued. The purpose of this article is to dive deeper into this question - are banks undervalued?

To do so, we first calculate the price to book for the regional banking and financial services sector from the end of 1998 to the end of 2015. Financial services can include any financial service such as financial advising, investment banking etc. Second, we plotted the price to book ratios against the 10-year Treasury note. Banks make their money from taking in deposits and loaning a percent of those deposits at a higher interest rate. If rates fall, then banks make less of a margin between the deposit and the loan. Naturally, we expect the price to book value to decline with the interest rate for the banking and financial service sector. In Figure 1, the 10-year Treasury yield is multiplied by one hundred in order to compare the yield against the price to book values.

Figure 1: Bank and Financial Services Price to Book vs. 10-year Treasury

As we expected, the price to book value for the banking and financial services sector declines with the 10-year Treasury yield. The conclusion here is that, an investment in the banking and financial services sector is a bet on the direction of interest rates. If interest rates increase, we can then expect the price to book ratio to increase as well. In other words, the market value of the banks should increase with an increase in interest rates. If rates continue to stay low, then banks are not as attractive investment.

None of this is too shocking. However, one notable thing we find in Figure 1 is that the price to book ratio for regional banks has historically traded in line with the financial services price to book. The average ratio of the financial services price to book relative to the regional banking price to book was 1.16 from 1998 to 2008. In other words, financial services price to book has historically traded 16% higher than the regional banking price to book. However, since 2009, the price to book ratios have diverged. In Figure 2, we display the ratio of the financial services price to book relative to the regional banking price to book.

Figure 2: Financial Services Price to Book Relative to Regional Banking Price to Book

In Figure 2, we notice that since 2009, the financial services price to book has traded on average 89% above the regional banking price to book. As of 2015, financial services price to book trade at 50% more than the regional banking price to book. We find that the regional banks are trading at a historically lower level than the financial services sector.

The conclusion is that there may be an opportunity in the regional banking sector. If one wants to invest in the banking sector, the play may be to invest in the regional banks versus the big banks. The advantages of the regional banks are they won't get broken up by regulatory bodies, are not tied up in complex financial transactions like the big banks, and have more opportunity to grow.

We searched out the best ETFs to gain exposure to the regional banks. The SPDR S&P Regional Banking ETF (NYSEARCA:KRE) provides 99% allocation to the regional banking sector. Other ETFs provide less of an allocation to the regional banks. The iShares U.S. Regional Banks ETF (NYSEARCA:IAT) allocates 77.24% to the regional banks and 19.53% to diversified banks. Other ETFs provide a similar allocation. The investment here is a regional banking investment; therefore, we recommend the KRE ETF.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.