Is It Time to Buy the Banks?

Since the beginning of the credit crisis last summer, bank stocks have been absolutely murdered -- the KBW Bank index, which tracks 24 of the most prominent U.S. commercial banks (including Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and JPMorgan Chase (NYSE: JPM  ) ) is down more than 40% from a year ago, at levels not seen in almost a decade.

However, I’ve learned it can pay to be contrarian. Distressed sectors needn’t repel you; when I sense that sentiment is unanimously negative, it’s like a dinner bell ringing in Pavlov’s kennel!

What was happening in the market 10 years ago?
Prior to 2008, the last time the Bank index was at this level was the fourth quarter of 1998. Russia had defaulted on its debt over the summer, precipitating the meltdown of hedge fund LTCM. In response, the Fed organized a private rescue of LTCM by a consortium of 14 banks and broker-dealers -- the fund’s massive positions were thought to threaten the stability of the financial system.

If that sounds familiar, it should -- the summer of 1998 offers direct parallels with the current environment. In March, for example, the Treasury facilitated JPMorgan Chase’s rescue of Bear Stearns on the assumption that the troubled broker’s failure posed an unacceptable risk to the financial system.

Cut to the chase: What’s it worth?
As serious as the current problems are, when a bubble deflates, it’s common for sentiment to shift from unbridled optimism to exaggerated pessimism. That spurred my curiosity: What is a fair value for the KBW Bank Index?

To figure that out, I used the justified Price-to-Book Value multiple. (The Price-to-Book Value (P/BV) multiple is commonly used to compare stock valuations; it’s calculated by dividing the stock price by the company’s book value-per-share. P/BV values for any stock can be found on Yahoo! Finance.)

Banks: Justify yourselves!
Instead of starting with the stock price, the justified P/BV is calculated based on the company’s fundamentals -- it’s the multiple at which the stock ought to be valued in light of those fundamentals. Specifically:

Justified P/BV = (Return on Equity - Expected Growth Rate in Earnings per Share )/(Cost of Equity - Expected Growth Rate in Earnings per Share )

Multiplying the justified P/BV by the company’s book value per share produces an estimate of the stock’s fair value. Calculating a justified P/BV for the index is no different; you simply use the fundamentals of the index.

The following table contains the results of these calculations for the KBW Bank index and six of its component stocks. The six stocks include three well-run banks that are riding out the crisis rather better than their peers (BB&T (NYSE: BBT  ) , M&T Bancorp, and Wells Fargo (NYSE: WFC  ) ) and three that are suffering tremendously (Citigroup, Wachovia, and Washington Mutual (NYSE: WM  ) ).

 

Justified P/BV

Fair Value

Current Price (08/26/2008)

BB&T

16.38

n/m*

$28.21

M&T Bancorp

3.50

$206.81

$68.41

Wells Fargo

(3.86)

n/m

$28.69

Citigroup

3.13

$62.72

$17.84

Wachovia

2.41

$73.80

$14.04

Washington Mutual

1.94

$25.90

$3.59

KBW Bank Index

0.84

$57.76

$62.26

*n/m = not meaningful. Sources: Capital IQ, Yahoo! Finance.

I made conservative assumptions at all steps of the calculation. My fair value estimate for the index should be thought of as a lower bound for the fair value; it represents a level at which the index is attractively priced. (If you would like to know more about the assumptions behind these numbers, I discuss them in my CAPS blog.) That said, what does the table tell us?

First, the multiples for individual banks are plainly useless, with some values negative and others that are off the chart. As a ratio, the price/book multiple is very sensitive to its three inputs (ROE, cost of equity, and EPS growth).

The multiple for the index, on the other hand, is derived as an average across 24 banks, so it’s much more stable. Another argument in support of its legitimacy: Its value jibes with my practical observations of the bank sector in July.

Capitulation in bank stocks: a diary
During the week of July 7, Fannie Mae and Freddie Mac were in the market’s crosshairs as investors wrestled with heightened fear concerning the financial position of the mortgage giants. These fears spilled over onto all financial stocks, including banks and broker-dealers.

By Friday, July 11, the fear felt all-encompassing. I bought shares of two U.S. banks that day, taking my exposure to bank stocks from zero to 14% of my portfolio. The KBW Bank Index closed at 54.67 on Friday, down more than 50% from a year earlier.

On Sunday, July 13, the Treasury and the Fed announced a raft of measures in support of the GSEs. Despite this, bank stocks continued lower during Monday’s session.

On Tuesday, July 15, in testimony before the Senate Banking committee, SEC Chairman Chris Cox said the SEC would implement an emergency measure to restrict the short selling of stocks of 19 financials, including Fannie and Freddie. The KBW Bank Index closed the day’s trading session at 48.47, recovering some ground from an intraday low of 46.52. The following day, the index soared, with a gain of 17%.

My point here is that my conservative fair value for the KBW Bank index (57.76) is only a bit higher than the values observed during the capitulation in bank stocks. That period (July 9-15) will go down as an extreme buying opportunity. For those who didn’t participate at the time, all is not lost. The index -- now priced at approximately 8% above my fair value -- doesn’t look overvalued.

My fair value estimate for the index may be a helpful benchmark, but I’m a bottom-up investor. I buy individual stocks; I don’t make bets on the KBW Bank ETF (AMEX: KBE  ) . In the second part of this two-part article, I’ll describe which banks investors should focus on as they comb through the sector.

Related banking Foolishness:

Alex Dumortier, CFA, has a beneficial interest in Wells Fargo and BB&T, but not in any of the other companies mentioned in this article. JPMorgan Chase, BB&T, and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy, which has suffered no impairments to its book value.


Read/Post Comments (16) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 29, 2008, at 9:01 AM, luvb2b wrote:

    THIS ARTICLE IS UTTERLY IRRESPONSIBLE. FOR SOMEONE TO SAY WASHINGTON MUTUAL IS WORTH $25.90 A SHARE AT FAIR VALUE IS A COMPLETE DISSERVICE TO ALL MOTLEY FOOL READERS.

  • Report this Comment On August 29, 2008, at 10:30 AM, TMFAleph1 wrote:

    luvb2b,

    Thanks for your comment, but it appears that you did not read my article in full. Below the table, I wrote: "First, the multiples for individual banks are plainly useless, with some values negative and others that are off the chart." I hope this helps to clarify my position.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On August 29, 2008, at 11:13 AM, luvb2b wrote:

    Then the article is poorly written.

    What I read in article asking if it's time to "Buy the Banks" is a bunch of useless company valuations provided in a section that is titled: "Cut to the chase: What’s it worth?"

    What I read is a multiple that derived by a formula that I've never seen, but you call a "justified P/BV". Justified by whom?

    As you said: "I buy individual stocks; I don’t make bets on the KBW Bank ETF (AMEX: KBE)." That implies that the valuations of the individual banks presented might have some value.

    If this was an article about buying an index, your table did little service to the value of the article, other than to highlight the worthless nature of the valuation metric employed.

    Regardless of your intent, the impact on individual investors of this article is to me, quite clear. On no news and with the futures and most financials gapping down, WM traded 5% higher this morning in pre market trading. A couple traders indicated it was because of this article. It is unfortunate that investors who would not immediately recognize the valuations presented as garbage would commit their capital on the basis of the same valuations.

  • Report this Comment On August 29, 2008, at 11:17 AM, luvb2b wrote:

    Oh yes, and let's not forget these two quotes that are on either side of the valuation table:

    "The following table contains the results of these calculations for the KBW Bank index and six of its component stocks."

    and

    "I made conservative assumptions at all steps of the calculation."

  • Report this Comment On August 29, 2008, at 11:26 AM, luvb2b wrote:

    By the way, here are just a few message board threads showing the individual investors that got baited by this bad article:

    Fair Value is $25+

    http://messages.finance.yahoo.com/Business_%26_Finance/Inves...

    Goodarticle on what WM and other banks are worth

    http://messages.finance.yahoo.com/Stocks_%28A_to_Z%29/Stocks...

    There are other such posts on several other message boards.

  • Report this Comment On August 29, 2008, at 12:38 PM, TMFAleph1 wrote:

    luvb2b,

    You quote the following sentence:

    "I buy individual stocks; I don’t make bets on the KBW Bank ETF (AMEX: KBE)."

    There is no reason to infer from that sentence that the fair values of individual banks presented in the table are valid -- particularly as I have stated explicitly in the article that they aren't.

    Furthermore, the sentence that follows reads: "In the second part of this two-part article, I’ll describe which banks investors should focus on as they comb through the sector." If I thought the fair values contained in the table were sufficient basis on which to make an investment decision, I would say so instead of taking the time to write a follow-up article.

    As far as the impact of my article, I will not take responsibility for the actions of people who are willing to put their capital at risk on the basis of a single article that they obviously haven't taken the time to read properly.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On August 29, 2008, at 12:54 PM, luvb2b wrote:

    "There is no reason to infer from that sentence that the fair values of individual banks presented in the table are valid -- particularly as I have stated explicitly in the article that they aren't."

    If the fair values are not valid, then why present them? Basically you just said you took a bunch of numbers, did something worthless with them, and derived invalid fair values. Then you wrote an article, and got it published.

    That's zero value added. Heck, negative value added. BOOOO!!!! HISSS!!!!!

    Perhaps you should take responsibility for an article that is not written properly?

  • Report this Comment On August 29, 2008, at 1:59 PM, fuzzy88 wrote:

    Book value is very misleading if used plainly. We all know the reason these banks got whacked was no one knows for sure if the loans in their books are good or bad, or more precisely, how bad.

    Without knowing the degree of badness (likelihood of defaults) of the book value, the P/B ratio is utterly useless.

    Also, talk about conservative, can you really justify that Wamu's justified ratio should be higher than the index when they are considered one of the at-risk banks?

  • Report this Comment On August 29, 2008, at 2:28 PM, joegonzalez481 wrote:

    I found your point of view tremendously interesting. You mentioned that it is a two part article. When and where can we see part two?

  • Report this Comment On August 29, 2008, at 3:04 PM, TMFAleph1 wrote:

    joegonzalez481,

    Thanks for your feedback; it's always nice to hear from interested readers. The second part of the article should appear during the first half of next week. Unfortunately, articles are not well cataloged within the Motley Fool. The only suggestion I can make is to perform a search on my name next week and sort the results by date. I realize this isn't very satisfactory, but it's the best option I can think of.

    Best,

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On August 29, 2008, at 3:08 PM, TMFAleph1 wrote:

    fuzzy88,

    Thanks for your comment. I agree with everything you have written. To answer your question: No, I can't justify Wamu's multiple being higher than the that of index (other than by slavishly invoking the formula). That is exactly what I meant when I wrote that "the multiples for the individual banks are plainly useless".

    Best,

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On August 29, 2008, at 6:39 PM, TicoHombre wrote:

    It would really be cool if people would learn to read before they claim that an article was useless.

    The author's points stood out clearly and understandably enough to me. But, then, I know how to read. E.g., his point that "the multiples for the individual banks are plainly useless" was exactly my thought after looking at the chart of examples, esp. WM.

    Thanks for the article!

    TH

  • Report this Comment On August 29, 2008, at 7:54 PM, TMFAleph1 wrote:

    TicoHombre,

    Thanks for your kind words -- they are appreciated!

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 10, 2008, at 1:59 PM, luvb2b wrote:

    Washington Mutual is now down almost 40% from the article.

    "E.g., his point that "the multiples for the individual banks are plainly useless" was exactly my thought after looking at the chart of examples, esp. WM."

    And again, I would say if the information is useless, why are you wasting our time with it?

  • Report this Comment On September 12, 2008, at 3:06 PM, limeonaire wrote:

    My question: What do you think about BAC?

  • Report this Comment On September 12, 2008, at 7:21 PM, dsafdary wrote:

    If WM get bought out over the weekend by JPM, what would that mean for current common stock holders? Do you think WM will pop up with that type of news?

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