The Most Undervalued Bank Stocks On The Market ... In A Single Investment

Includes: IAT, KRE
by: StreetAuthority

By David Sterman

It's easy to see the appeal of banking stocks. Many of them sport low price-to-earnings (P/E) ratios while trading below tangible book value. My favorite bank stock -- Citigroup (NYSE: C) -- for example, still trades for just 57% of tangible book and less than seven times projected 2013 profits, even after a recent 20% gain during the past month.

Yet many major banks, with operations across the globe, still remain vulnerable to shock waves emanating from Europe and elsewhere. That's why they are so cheap. When the global risks fade away, these banks could post a huge rally.

If you can't stomach the risk that these big banks bring, then why not focus on the next tier? Regional banks possess many of the same traits as the large banks, but often have zero foreign exposure.

In the second quarter, the five regional banks in the table below all exceeded consensus forecasts, highlighting the fact that operations are a bit stronger than analysts have given them credit for. They all trade for less than 10 times earnings, making them inexpensive in terms of trailing profits and book value. It's worth noting that all are capable of stronger earnings once the housing market and the broader economy perk up.

The Regionals Remain Inexpensive

Meanwhile, most trade for around book value, well below the 1.5-2.0 multiple to book that regional banks garner in a normalized economic cycle. The key profit drivers to come: rising lending activity, a reduction in nonperforming loans and an expansion in net interest margins as interest rates revert back to historical norms.

Craig Siegenthaler, who follows regional banks for Credit Suisse, says a rebound is already under way. He has found that the number of nonperforming loans at many banks has been steadily dropping. More important, lending activity appears to be picking up, especially as it relates to the housing sector and small business capacity expansions. "This tells us that pockets of construction demand are beginning to emerge," notes Siegenthaler.

My colleagues have already given some solid ideas if you are looking for high-yielding regional bank stocks. Amy Calistri, the face behind StreetAuthority's The Daily Paycheck, profiled this group back in February, while Carla Pasternak, editor of the High-Yield Investing advisory, took note of these regional bank stocks back in January.

But if you're talking about the biggest regional banks, then it becomes a challenge to single out a specific stock, as they tend to trade in tandem on the backs of broader sector interest. That is to say, a rising tide will eventually lift all boats.

That's why an exchange-traded fund investment makes more sense. Regional Bank ETFs give you exposure to the whole group without the need to track lending activity at one particular institution.

A pair of choices
Though there are a number of ETFs that have some degree of exposure to regional banks, a pair of them provide the most direct access to the leading regional banks.

1. iShares Dow Jones U.S. Regional Banks index (NYSE: IAT)
This is a cap-weighted fund, which means that the bulk of its $95 million asset base is tied up in bigger regional banks. For example, the top 10 holdings account for 64% of the fund's portfolio, led by U.S. Bancorp, which accounts for 21% of the total fund.

2. SPDR S&P Regional Banking ETF (NYSE: KRE)
The big drawback of the iShares fund is the 0.47% expense fee, which can eat into profits for investors looking to trade in and out of the ETF. The SPDR S&P Regional Banking ETF carries a slightly more reasonable 0.35% expense ratio and provides better access to a broader spectrum of regional banks and not just the biggest players. For example, the average holding in the iShares Dow Jones fund is valued at about $10 billion, while the typical SPDR fund holding is just $2 billion. In fact, more than three-fourths of the 71 holdings are considered to be small-cap banks, according to Morningstar. Still, it's a relatively large fund, with more than $1 billion in assets in the fold.

Risks to Consider: The U.S. economy appears to be weathering the global storm in decent shape, but a broader global economic meltdown would surely affect the U.S. economy, which would dampen results at these regional banks.

This is a multi-year play. The regional banks have spent the past few years getting their houses in order after the Great Recession that began in 2008. Now, they are in shape and poised to generate further profit gains as the economy strengthens. Right now, analysts aren't looking for big profit spikes in 2013, largely because the economic outlook for the United States remains a bit murky. But whether the U.S. economy lifts this group's results in 2013 or 2014, you shouldn't wait too long as these stocks (and ETFs) already represent solid value at current levels.

Disclosure: David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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