Are Bank Stocks Buyable?

The crisis among financials in general and banks in particular is one of the worst-kept secrets around. Less clear, however, is an appropriate investment strategy. Market veterans have seen many groups over the years recover from many crises and know the time to buy is when things still look bleak. But they also know how painful it can be to jump in too quickly. Lately, buying interest in banks has picked up, leading one to wonder if now is the time to get in.

Light at the end of the tunnel?

Notwithstanding all the noise about securitization, structured derivatives, aggressive hedge funds, and so forth, the nature of the U.S. financial crisis is actually quite easy to understand: too many companies got too enamored with growth and too cavalier about risk and loaned too much money to borrowers who couldn't repay and supported those loans with security interests in assets whose so-called values proved unsustainable.

Sub-prime mortgages are an old story, and by now, it looks like the world at large is well aware of problems with other categories of lending. Throughout the financial sector we've seen write-offs galore, shotgun mergers (Will Lehman Brothers (LEH)be next?) , and the announcement of a sort-of nationalization of Fannie Mae (FNM) and Freddie Mac (FRE) which suggests that right or wrong, for better or worse, Washington is determined to avoid letting the whole thing go completely down the drain.

All this raises the classic investment question: whether enough bad news is already out there to justify buying in anticipation of the next upcycle. Judging by the performance of two bank-oriented ETFs, SPDR KBW Bank ETF (KBE) and SPDR KBW Regional Banking ETF (KRE), it looks like many are answering in the affirmative. KBE, focusing on larger money center banks, after having fallen 52.55 percent from its 2/20/07 peak to its 7/15/08 trough, closed yesterday 57.8 percent above its bottom. KBR, the regional offering, moved pretty much in lockstep, falling 57.50 percent from peak to trough and bounding 52.38 percent from the low.

I'm not such a banking expert as to suggest I can predict if any more shoes are yet to drop, or if so, how many. (I'm not sure that's such a handicap considering how many more knowledgeable people failed to call the top.) But based on some research conducted on Portfolio123.com, I am able to discern a significant and potentially actionable change in Wall Street's approach toward bank stocks.

Conservative criteria for ranking bank stocks

Assuming I'm right in assuming that over-aggressiveness has been at the root of the problems seen in banking, it would seem possible to construct a ranking system designed to favor conservative (relatively speaking) banks. I would expect such a system to have done a poor job in picking winners during the recent heyday, when profit maximization was the mantra and risk was on the back burner, but to have performed much better more recently, as things came apart.

Here are the factors I used:

• Trailing 12 month growth in Interest Income: For banks, this is the equivalent of sales growth. Usually models incorporating sales growth equate higher growth to higher desirability. This model does the reverse, it favors lower levels of growth. That's consistent with the notion that much of the trouble we've seen relates to the aggressive pursuit of more and more growth. Standing alone, this would not appeal to even conservative investors, who may frown on aggressiveness, but don't want the other extreme either. But here, lesser growth does not stand alone . . .
• Trailing 12 Month Lending Margin: This is net interest income divided by interest income. The difference between the two is interest on deposits, borrowings and securities held. Arguably, the conservative investor would be more interested in seeing the margin after deduction for the loan loss provision, but I elected not to do that here, since the latter item is likely to surge suddenly nowadays, making it difficult to draw conclusions from past histories of moderate results. I'd rather, instead, model an overall conservative mindset, one that would, hopefully, make the bank less prone to future jolts in the loan loss provision. Unlike the case with income growth, with margin, higher tallies equate to more desirability. Putting this factor together with the first, I'm more interested in banks that lean toward slower but profitable growth, as opposed to those who slash margins to "buy" lending share.
• Equity Multiplier: This is total assets divided by equity. The model favors lesser tallies, which signify lesser tendency to use leverage. This is viewed relative only to other banks. (Even the most conservative banks normally work with more leverage than the typical industrial firm.)
• Trailing 12 Month Return on Assets: This is a very standard measure of overall corporate profitability, and consistent with normal usage, higher tallies are favored here. For industrials, I'd be more likely to use Return on Equity of Return on Investment. But for banks, it's more useful to look at the entire asset base, especially since this model includes the equity multiplier and, hence, is not ignoring the issue of leverage.

The factors were equally weighted and were applied to banks whose shares are included in the Russell 2000 index, a generally less famous/infamous group that seems more likely to trade on the basis of reported fundamentals rather than headlines, gossip, emotion, and so forth.

Back-testing the system

Figure 1 shows the results of a Portfolio123.com back-test focusing on 3/31/01 through 12/31/06, when return seemed to have been exalted over risk. The left-most red bar represents the annualized performance of the S&P 500. The second, blue, bar represents the banks rated in the bottom 10 percent, The right-most green bar depicts the annualized performance of the banks stocks rated in the top 10 percent.

Figure 1: 3/31/01 - 12/31/06

The results show that in the recent heyday of banking, a model geared toward conservatism would have been essentially useless in helping to identify potential stock market winners. If anything, there's was modest tendency for stocks with lower ratings to have performed better, suggesting that the Street, to the extent it considered risk at all, was perfectly content to see it dialed up. This is consistent with my initial expectation.

Figure 2 picks up the story as we move toward the present, the period when risk re-asserted itself in an often-painful manner.

Figure 2: 1/1/07 - 9/9/08

What a difference a time of reckoning makes. The ten groups aren't in perfect performance order, but it's clear that during this time period, the model is providing us with useful information. As we know, the market as a whole is down and the overall bank group fell further. But now, it's clear that investors who want to own banks are identifying aggressive strategies and running in the other direction.

Figure 3 takes a closer look at a more recent slice of time and continues to show that banks have underperformed a weak market but that within the group, investors are emphasizing conservatism, and now, to a slightly greater degree than we saw in Figure 2.

Figure 3: 7/31/08 - 9/9/08

Interpreting the results

One way we could react to a model like this is to buy highly rated bank stocks hoping they'll continue to rally but expecting that if more bad times lie ahead, as would seem likely if we get more Lehman-like news, the stocks we own would suffer less.

We might also view a model like this as providing something of a sector signal.

It would be nice to think that bankers and investors have learned their lesson and will be more prudent in the future. Realistically, though, I wouldn't bet the farm on that. This isn't the first time over-aggressiveness got banks into trouble, and absent very substantial new federal legislation (a comprehensive scheme of day-to-day business regulation, as opposed to one-off crisis remedies), it probably won't be the last. If that's so, it seems reasonable to assume this model will cease to identify better performing bank stocks once investors start looking past the crisis. In that case, when the lesser-rated stocks outperform (or even improve substantially relative to) higher-ranked stocks, one might take that as a signal that the bank group as a whole is more buyable.

The latter interpretation would suggest that what we saw with the aforementioned bank ETFs was more in the nature of the dead-cat bounce. Unless you are willing to assume we're in a new era where conservatism will prevail even in better times (an assumption I'm not yet ready to make), we'd have to expect a sustainable upturn to incorporate more willingness on the part of investors to own the aggressive banks.

Here, in Tables 1 and 2 respectively, are the current listings of high- and low-rated Russell 2000 bank stocks.

Table 1

Table 2

Disclaimer: The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Neither Prism Financial, Inc., owner of Portfolio123.com, nor Marc H. Gerstein, an independent contractor working with Prism (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation.

Comments

[biomedlives:]

The list of criteria looks good, but I believe it needs an addition that reflects the level of non-performing assets and the adequacy of the loan loss reserve.

2008 Sep 10 10:48 AM

[bsharvy:]

No valuation criteria, e.g. P/B....

2008 Sep 10 11:29 PM

[Philip Gvinter:]

I am very bearish on bank stocks but do agree that these are good screening criteria. There are still four major factors which are likely to mean more trouble for banks.

The first is the negative equity in car leases. All truck and many car and luxury car leases written in the last three to four years have residual values significantly above the current market value of the vehicles, in many cases the difference exceeds $10,000 per vehicle (take a look at the prices of used luxury cars and mid size and full size trucks right now and compare them to what they were a year ago for vehicles of similar age and mileage, the difference is shocking) which is a tremendous hit to the institution which must take back and sell the vehicle.

The second issue is the upcoming recast of billions of dollars worth of Pay Option ARMs. These exotic mortgages allow borrowers to pay less than the interest due while growing the balance to a cap of 110%, 115% or in some cases an insane 125% of the original balance. When this cap is reached the payments more than double. Most of these loans were done with no documentation of income and are therefore as toxic as the subprime loans. This will add more foreclosure inventory to the already weak housing market and will severely punish those banks which hold these loans on their balance sheets. The biggest holder of these loans is WB with over $120B in their portfolio.

The third issue standing in the way in the way of a banking recovery is the performance of credit card debt. Because consumers used their home equity lines to pay down their credit card debt during the housing boom/bubble they have found themselves with one last avenue of available credit. Defaults in the credit card portfolios of COF and AXP have accelerated and in my opinion will continue to do so as cash strapped consumers use the credit cards to continue to fund purchases which they cannot afford. At this point these purchases are no longer limited to lifestyle desires such as eating out or new luxury goods but now include the increasingly expensive price tag of groceries and gasoline.

The fourth and final issue is the rising rate of unemployment. Increased unemployment means increased levels of default across all classes of consumer loans, and at some point begins to seep into commercial lending as a slowdown of consumer spending hurts small businesses. The continued rise in unemployment numbers and the acceleration of this trend does not bode well for the banking industry.

As I said before while I fully agree with the authors methodology I still believe that looking into bank stocks is premature at this point and will continue to be premature until a bottom is found in the housing market and a top has been reached in the accelerating unemployment statistics.

2008 Sep 11 08:58 AM

[Marc Gerstein:]

I get a sense the market is more or less tuned into credit cards and the employment issue. But the care leases and pay option ARMs still seem to have the potential to surprise. And outside the strict confines of banking per se, people (other than sell side analysts) had been worrying about Lehman and that shoe fell hard. Bear is gone. Now . . . are there any more to surface? So it seems unsurprising that that the banks stocks that bounced most were the most conservative, the type least likely to carry a sustained rally.

BTW... the reason I didn't use valuation or loan loss criteria is because right now, I'm not comfortable with the #s. Good loan loss #s may mean good lending habits, or it may mean that they haven't yet ... but will soon .. take the big charges. That would also play havoc with the valuation, metrics. Down the road, once life normalizes (however long that may take), valuation and loan criteria would definitely be important.

2008 Sep 11 11:38 AM

[Philip Gvinter:]

A large part of my bearish sentiment stems from the systemic deterioration of underwriting standards in the mortgage and commercial loan markets. Standards were relaxed on all programs including prime and AAA commercial credit. I believe that the true scope of the consequences of radically relaxing loan standards right before the economy heads into an average to severe recession will have. In my opinion default predictions for prime, prime jumbo, auto and credit card loans as well as small business loans, construction loans, and floating rate debt held by large corporations are still too low. From first hand experience I can tell you that a significant portion (greater than 20%) of mortgages underwritten and purchased by the GSEs would not have passed muster under any other period and is far from prime quality. While I agree that the more conservative banks stand to profit handsomely with the elimination of overly aggressive competitors and the availability of prime assets which would otherwise never be for sale at discounted prices. At the same time I feel that the credit contraction is only starting in earnest. The issue holding back a more expedient end to the necessary contraction is the low quality and illiquid nature of the assets which need to be liquidated off of bank and other financial companies' balance sheets. Because there are no willing buyers for the fixed income exotica created over the last four years it is incredibly difficult for institutions to fully clean out their balance sheets. Until we see some stable pricing and a slight increase in the number of large distressed debt deals in order to be able to ascertain the eventual trading prices of these massive piles of securities which will ultimately reveal the state of many banks real balance sheet health. Another key factor is the fact that there is no real way to at this point accurately predict where the unemployment rate and the housing drop will end. Until such data becomes a reasonable topic of discussion I feel that it is entirely premature to look for investment opportunities in the banking sector as the outcome of these macro events make such an investment perilously close to a roll of the dice.

2008 Sep 11 12:50 PM

[kurt walter:]

What is the point in owning any bank stocks? Do we have to try to pick an absolute bottom to make money in the long term. Most banks are a black holes of financial nonsense. Nobody really knows what they are worth. I do know that lots of pay option ARMs are going to be adjusting in 2009, 2010 and 2011. So there is no rush to own this toxic waste.

2008 Sep 11 02:26 PM

[biomedlives:]

Marc - If you're referring to chargeoffs when you discuss loan loss criteria, I agree with your logic completely. I pay much more attention to the level of non-performing assets than to chargeoffs, because I believe banks have less discretion in defining NPAs.

2008 Sep 12 09:03 PM