Time to Buy the Banks, but Which Banks to Buy?

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In last week's "Is It Time to Buy the Banks?" I looked at evidence suggesting the banking sector may be ripe with interesting investment opportunities. In the second installment of this two-part article, I'll take a look at which banks investors should be focusing on to achieve superior returns.

In case you haven't read (or don't want to read) the first part, let me give you a little anecdotal evidence to support my thesis that the U.S. banking sector is a rich hunting ground for investors: I can rattle off multiple references to exceptional investors that have stated it.

This is "innocent money"!?
Only last week, an official from Temasek, an investment arm of the Singaporean government, said: "We recently concentrated on U.S. and UK [financial services] primarily because we see value." Temasek owns 9.4% of Merrill Lynch (NYSE: MER  ) .

Warren Buffett can dismiss sovereign wealth funds as "innocent money," but Temasek has achieved 18% annualized returns since 1974 – those are hardly the numbers of a lamb to the slaughter!

With that said, let's examine the current valuations of two groups of stocks in historical context. I've got three "good" banks that have fared rather better than their peers during this credit crisis: BB&T (NYSE: BBT  ) , M&T Bancorp (NYSE: MTB  ) , and Wells Fargo (NYSE: WFC  ) . And three "bad" banks that have had a dreadful time of it: (Citigroup (NYSE: C  ) , Wachovia (NYSE: WB  ) , and Washington Mutual (NYSE: WM  ) .


P/BV at 09/04/2008

Previous Low in P/BV*

Annualized Return Since Previous Low in P/BV

Outperformance Over KBW Bank Index (ann.)

Outperformance Over S&P 500 (ann.)



12/08/1994 (1.09)




M&T Bancorp 


12/27/1994 (1.31)**




Wells Fargo 


12/01/1994 (1.90)






05/12/1994 (1.24)***






12/08/1994 (1.30)****




Washington Mutual 


11/22/1994 (0.87)***




*Prior to the start of the credit crisis. **Low for available data beginning on 01/01/1992. *** Low since 01/01/1993. ****Low since 01/01/1994.
Source: Capital IQ, Yahoo! Finance.

There are a couple of things that jump out from the table: First, one has to go back almost 14 years to find book value multiples as low as they are currently. In addition, the lows are tightly grouped -- within a 45-day period at the end of 1994 for five of the six stocks.

What happened to bank stocks in the fourth quarter of 1994?
For the whippersnappers out there, here's a market history recap: In 1994, the Fed instituted a series of unexpected rate hikes, sparking heavy selling in bank stocks. Higher rates mean higher funding costs for banks. Investors were concerned their margins would be squeezed. Market sentiment toward banks was very negative; valuations were depressed.

Since then, our three good banks have easily outperformed the KBW Bank Index and the S&P 500 by an average of 8.5% and 8% on an annualized basis, respectively.

(Note that the stated outperformance is inflated due to the fact that the annualized returns calculated for the KBW Index and the S&P 500 do not include dividends. Even if we generously assume average dividend yields of 5.5% and 4% for the KBW Bank Index and the S&P 500, respectively, the margin of outperformance remains impressive.)

Furthermore, I calculated outperformance over a trough-to-trough period. The numbers would surely be even more impressive if bank stocks were not currently depressed.

On the other hand, our bad bank sample has performed disastrously, losing an average of 2.8% and 3.5%, respectively, to the KBW Bank Index and the S&P500 on an annualized basis. (Citigroup is the standout in the group, more on this later.) Note that in this case, accounting for dividends would produce a margin of underperformance that is even greater, not smaller, than my figures show.

Things look pretty clear cut -- is it really that easy?
The data appear to paint an obvious picture: "Buy the 'good' banks; sell the 'bad' ones." But let's be mindful of look-back bias: Do the banks in each set really share anything beyond their performance in the current environment? Would we have grouped them in the same way at the end of 1994?

I submit that there were objective elements that might have enabled investors to sort these banks into two groups in 1994 -- or at the very least identify the good ones. Banks in our first group are regarded as well run, conservative lenders. The second group might also have been described as well run ... in good times. However, they simply don't have the same culture of prudent lending and risk management.

Even the best performer among our bad banks was in grave difficulty only a few years earlier due to poor lending practices. In 1990 and 1991, Citicorp (the predecessor entity to Citigroup) was faced with severe losses on loans, including $13 billion in commercial real estate loans, more than a third of which were concentrated in the western United States. By 1991, 40% of the real estate loans were nonperforming.

Urged by the Fed to strengthen its capital position, the bank sought fresh capital, including $590 million from Saudi investor Prince al-Waleed bin Talal in February 1991.

The only competitive advantage a bank will ever have
Lending discipline, fostered by a strong culture and adequate processes, is perhaps the only sustainable competitive advantage in banking -- something that is poorly understood by many investors. Capital is fungible, and neither technology, nor innovation provides a durable advantage. (In fact, I'd be a little skeptical of banks that are always at the forefront of the industry; some banks can be too innovative for their own good.)

Of course, institutions can change over time. In the years after World War I, for example, "Washington Mutual had a hard earned reputation as one of the strongest and most fundamentally sound savings and investment institutions in all of Washington State." Simply buying bank stocks that have performed well over the previous credit cycle won't do the trick -- one must ensure that lending discipline remains rock solid (for starters).

Banks have done gangbusters since mid-July -- am I too late?
Since their July 15 lows, banks have staged a huge comeback rally: The KBW Bank Index is up more than 35% since then. The mid-July period was undoubtedly an extreme buying opportunity, and investors who didn't take advantage of it may be convinced that they've missed the boat.

That could well be the case if your time horizon is measured in months. If, however, you can extend it out to 10 years and longer (which you should do if you are thinking of investing in stocks at all), our table suggests there are still some excellent opportunities left in the sector. In my judgment, all three of our "good" banks are likely to outperform the sector and the overall market over the next 10 years.

Going back: Buffett on Wells Fargo
I'll leave you with an excerpt from Berkshire Hathaway's 1990 letter to shareholders. Here, Warren Buffett describes the environment in which he made a massive purchase of Wells Fargo shares (Berkshire is Wells Fargo's largest shareholder):

"Our purchases of Wells Fargo ... were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted."

Does that sound familiar?

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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. BB&T is an Income Investor recommendation. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (20)

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  • Report this Comment On September 06, 2008, at 12:58 AM, ginrai wrote:

    "Warren Buffett can dismiss sovereign wealth funds as "innocent money," but Temasek has achieved 18% annualized returns since 1974 – those are hardly the numbers of a lamb to the slaughter!


    I would advise you to take that 18% figure with a pinch of salt for a number of reasons :

    1. Temasek is not transparent. They never make their balance sheet public. To my knowledge, the only ones who may have seen it are the US regulators who were opposed to wealth funds buying huge stakes in US banks.

    2. The Chief Executive is the wife of the Prime Minister of Singapore. The chairman of GIC, another Singapore wealth fund is the father of the Prime Minister, and himself, the former Prime Minister. With such extreme instances of nepotism going on, it would be pretty easy to fudge that figure. If you think American politicians are corrupt, they are put to shame by Singaporean politicians.

    3. If you were to look at major investments by Temasek over the past couple of years, they have all done badly. (Barclays, Merrill Lynch, ShinCorp, and some telcos).

    This can never be a more classic situation of the blind leading the blind.

  • Report this Comment On September 08, 2008, at 11:32 AM, TMFAleph1 wrote:


    Thanks for your comment. I'm aware of the points you make, but I disagree with most of them.

    For one, Singaporean politicians are less corrupt than their U.S. counterparts. Note that The Economist published a piece on Temasek in 2004 which made the same criticisms you do: lack of transparency and nepotism. With regard to the charge of nepotism, The Economist printed an apology to the Lees two weeks later and paid damages totaling S$390,000.

    Furthermore, there is another fundamental difference between Singaporean and American politicans -- the former are competent.

    I'm not familiar with Temasek's investments in ShinCorp/ telcos; however, as far as their investments in Barclays and Merrill Lynch are concerned, I think it is very premature to judge whether or not they are successes.

    Thanks again for your comment,

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 09, 2008, at 6:45 PM, ginrai wrote:


    As a native Singaporean and one who has been living in the US for the past 7 years, let me share a little bit of knowledge.

    All foreign publications are heavily regulated and publishers are required to put up "bond" money. In case they run afoul of the government, this money will be used to settle legal disputes (See the case of the Far Eastern Economic Review).

    Now, as for the Economist paying damages, let me state one thing very clearly : The judiciary in Singapore is NOT independent (check out the cases of opposition politicians being sued for non-existent slander).

    Now, the reason you might find Singapore scoring high grades on studies done on government corruption, is because all the corruption is LEGALIZED.

    "Don't like a law? Never mind, pass a new one that works in our favor. After all we control 82 out of 84 seats in Parliament." This is the way politics in Singapore work.

    Tell me, where in this world do you have a 1st world democratic nation whose ministers' salaries run into the millions, without any accountability? I, for one, know that the President of the United States gets $400,000 a year. The icing on the cake was that their already sky-high pay increased last year despite the Singapore economy not doing well.

    I don't know how you judge Singapore politicians to be competent. I find that they are equally as incompetent as American politicians.

    I can list down may examples of their incompetence and lack of accountability, but the list will be too long. Let me give you one example of how they let a dangerous terrorist escape last year.

    Now, as for the money that Temasek invested in Barclays and MER, let me enlighten you where that comes from. Singapore has a forced savings system, much like a 401k, but compulsory. Every month, 20% of your salary will be held in this account. Your employer contributes 13%. This is where Temasek draws its funds from.

    Now, if I were managing the retirement savings of a nation, I would definitely be more conservative. I have financial holdings too, Barclays. However, my cost average is just under $20, I bet much lower than what Temasek paid for since they bought a huge amount at the peak in 2007. If you care to take a close look at MER's balance sheet, I don't think you would actually consider it a good investment. What they are doing is more like speculating, rather than investing.

    Now consider these facts:

    -Years ago, you were allowed to withdraw all your retirement savings at 55

    -The Singapore government later changed it to 62.

    -They then changed the law such that you had to set aside a minimum sum in that account.

    -Last year, they were contemplating passing a law making the purchase of an annuity, using that minimum sum, compulsory. Here's the catch : The annuity payments would start at 85. If you passed away before then, your moeny would go to a "common pool". There was an especially large outcry so much so that they promised to review this.

    As for Temasek's investment in the Thai telco Shincorp, I got to hand it to the CEO of Temasek. She indirectly or directly caused the elected government of Thailand to get removed in coup.

    Not too long after their botched investment, sales tax was increased from 5% to 7%. The reason? To help the poor, so they say.

    These are just the tip of the iceberg. The US may have corrupt and incompetent politicians, but Singapore is no better.

    I will understand if you choose to ignore my ranting and raving. After all, if you've been to Singapore, it's so clean, safe, and organized, right? Try going through the conscription service and living there for 10 years and the facts will slowly unfold before your eyes.

    The bottomline is that I hope you don't make your investment decisions based on what a sovereign wealth fund does, especially one that is arguably as shady as Temasek. As always, doing your own research is the best.

  • Report this Comment On September 09, 2008, at 7:33 PM, TMFAleph1 wrote:


    Thanks for your follow-up comment, which certainly provides a "feet on the ground" perspective to my knowledge of Singapore, which is admittedly more academic.

    I absolutely agree with your last point -- I don't recommend that anyone make an investment decision based solely on what another investor does, no matter how successful they are. This was simply a small piece of anecdotal evidence in support of the thesis. Note, however, that Temasek are not the only investors to suggest that financial services is an area of immense opportunity during this crisis. J.C. Flowers (J.C. Flowers & Co.) and David Rubenstein (Carlyle Group) have made statements to this effect. Of course, their statements were not time-bound and financial services covers more than simply U.S. commercial banks.

    Thanks again for following up!

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 09, 2008, at 8:13 PM, ginrai wrote:


    I agree that there is immense opportunity during this crisis. There are many well-managed banks that are getting unfairly pounded along with the bad apples. However, if I had to bet a dollar to save my life, it definitely would not go to Merrill Lynch.

  • Report this Comment On September 09, 2008, at 8:23 PM, ginrai wrote:

    What I did not agree with was using Temasek as a positive example. In a way, Buffett had some valid points when describing the investment style of sovereign wealth funds (in this case, Temasek).

  • Report this Comment On September 10, 2008, at 4:12 PM, PennyPincher12 wrote:

    I wish I could buy bank stocks right now, but I don't really understand how their businesses operate.

  • Report this Comment On September 12, 2008, at 5:12 AM, BM7 wrote:

    Alex, don't take Ginrai comments as the gospel truth. I am Singaporean, have spent quite some time overseas but can definitely put a real feet on the ground perspective.

    The comments given smack of biased criticism of the system here.

    Sure, decisions of the government here and I suppose the investments of GIC and Temasek cannot always be spot on, but generally most of us have not much to complain about over the last decades as this same government moved us from a backwater to success story in many fronts – finance, education etc.

    As you said, time will tell on their investments, but surely sovereign wealth funds can afford to look at the very long term - my guess is that they won't be too far wrong.

    BTW the “forced” savings systems implemented is a good thing in my view – better than relying on higher taxes in a welfare state.


  • Report this Comment On September 12, 2008, at 9:34 AM, ginrai wrote:


    I believe that we are digressing here as the original intent of your article was to talk about finacials being good buys.

    I also happen to have stock in WFC and would appreciate your views on this bank.

    Lastly, let me leave you with 2 facts(not my opinions). You can draw your own conclusions from there.'s_Action_Party#Internet

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