Don't Even Think About Buying Bank Stocks

"Buy when there's blood in the streets."

How many times have you heard that one? If you really want to make a killing in the market, it's one of the best creeds to follow.

Right now, there's no shortage of blood in the banking industry. Almost every bank is stumbling around and aimlessly hoping that their tourniquets will hold until the next day. Forget blood in the streets … we're talking about mangled guts at your doorstep.  

So is it time to back up the truck and buy some bank stocks?

In the name of everything holy, no
Investors right now aren't giving two thoughts to a bank's future income potential; they're solely focused on whether the bank is adequately capitalized -- essentially, whether or not it has enough of a cushion on its balance sheet to be able to absorb future woes.

The simplified version of this calculation is just assets minus liabilities. That's what's left over as shareholders' equity, and it's what a bank relies upon if its assets head south. The caveat here -- and the reason you should be extra careful when looking at bank stocks -- is that not all assets are created equal.

Goodwill, meet badwill
It isn't just capital you should be looking at when valuing banks, but tangible capital. The difference is that tangible capital strips out things like goodwill, trademarks, brand names, and patents. It's not that those assets don't have long-term value, but they mean squat when it comes to being able to cover existing liabilities at a given time, short of selling entire pieces of the company. Try telling your landlord that you don't have any actual cash but that you have a super-cool last name and your friends think you're totally awesome, and you'll understand what I'm talking about.

Furthermore, when we're talking about common stocks, we have to take into consideration the value of preferred shares that take precedence. This is obviously important right now, because so many banks are issuing gobs of preferred shares to Uncle Sam and big investors like Warren Buffett. Since those investors will be taken care of before common shares see an honest dime, it's only fair to strip out their value to gauge what's left for Joe Typical Common Shareholder.

When you take shareholders' equity, exclude the value of intangible assets, and strip out preferred stock, you get a figure we'll call "tangible common shareholders' equity." This figure essentially represents the buffer between common shares you can purchase in the open market and having those shares be close to worthless.

With that in mind, check out these big-name banks:

Company

Total Assets

Tangible Common Shareholders’ Equity

Effective Common Shareholders’ Leverage

Citigroup (NYSE: C  )

$2.1 trillion

$36 billion

58 times

Bank of America (NYSE: BAC  )

$1.7 trillion

$51 billion

34 times

JPMorgan Chase (NYSE: JPM  )

$1.8 trillion

$76 billion

24 times

Wells Fargo (NYSE: WFC  )

$595 billion

$34 billion

17 times

Goldman Sachs (NYSE: GS  )

$1.1 trillion

$37 billion

29 times

Morgan Stanley (NYSE: MS  )

$987 billion

$31 billion

32 times

General Electric* (NYSE: GE  )

$830 billion

$14 billion

61 times

Data as of the most recent quarter available in Yahoo! Finance. Does not include preferred shares issued by Treasury in October.
*Not necessarily a bank stock, but still has a substantial finance arm.

Just don't do it
When you look at that table, it becomes apparent why a company such as Citigroup can be down 75% year to date, even after receiving two infusions of government preferred shares. You can essentially think of Citigroup's common stock as an investment in a hodgepodge of assets littered with collateralized debt obligations, mortgage-backed securities, and who knows what else, all levered up roughly 58 times over. If that sounds attractive to you, enjoy the ride. These companies are still utterly leveraged to the gills.

None of this is to say that all, or even any, of those companies will end up making poor investments. Some could easily end up being bargain buys at today's prices. Still, the obvious risk that still lies in these common stocks is just ridiculous. What's as important today as it's ever been is that investors remember about return of capital, rather than just return on capital.  

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. The Motley Fool is investors writing for investors.


Read/Post Comments (7) | Recommend This Article (31)

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 November 26, 2008, at 8:10 PM, Ohseaseer wrote:

    Well, first it was Rich Duprey making an absurd disc on WFC due to the fact they offered a payday loan attached to checking accounts, now it is Morgan Housel saying WFC is at risk by inserting it against companies with much higher leverage. Where is the Buffet metaphor, where is the go to CAPs for insights you should expect from TMF. I think TMF has run its course... half Buffet and half CAPs and -0- investment advice... Unless you want to consider LYG or LM or USG... what the heck. Tom told me when I complained to be civil and post... Ok, I am being civil Tom... but I'll bet TMF will drop this post as soon as it is read.

  • Report this Comment On November 28, 2008, at 3:40 PM, kh101 wrote:

    I am confused by the article and hope someone might clarify it for me.

    The article says that these stocks are a dangerous risk because the businesses are too highly leveraged.

    But it does not discuss how much liability any of them have. How can you know if a stock is a serious risk simply by comparing listed assets with tangible equity as defined here? [Unless "tangible equity" takes into consideration liabilities and I am missing how that was done here.] Effective leverage is undefined in the article - maybe that is the explanation i am missing that would make sense of what is being discussed. As it stands, I have no idea how the heck the writer came to his conclusion based on the information presented. What am i missing?

  • Report this Comment On November 28, 2008, at 7:45 PM, RBFC wrote:

    "Don't Even Think About Buying Bank Stocks" Silly headline that lumps all bank stocks into one group. There is opportunity that just needs research.

  • Report this Comment On November 29, 2008, at 2:53 PM, fred2012 wrote:

    Another excellent reason to buy, the talking heads have decided to finally dump banking stocks. A year ago no one would believe that banking stocks would fall as far or as fast. Now after all the damage is done you warn not to buy? I can't think of a better time to buy than when the so called long term investors decide that this fundamental industry will no longer make money. This is exactly the time to buy. I bought 10k shares of uyg with an 11% dividend. I think this could be the best buy of my life!!!!!!!!!!!

  • Report this Comment On November 29, 2008, at 2:57 PM, fred2012 wrote:

    by the way i am already up 55% for a week and a half.

  • Report this Comment On November 30, 2008, at 7:06 AM, NuvoRiche wrote:

    From the point of view of the Buffet-style LTBH value investor, this article doesn't make any sense. Risk is inherent to the stock market, and often commensurate with opportunity. I see good value plays on the list. I wouldn't bet the farm on any of these, but I wouldn't discard certain of these companies, particularly WFC, as being unable to effectively deal with their leveraged assets. In the case of WFC, the pain is tempered by massive tax write-offs - which is what enabled and prompted the WB "purchase"; when the recession lifts they will be left with a nationwide brick-&-mortar network that THEY WERE PAID TO TAKE. This article was pretty weak, and contrary to many other articles by the Fool supporting the premise of value investing.

  • Report this Comment On November 30, 2008, at 7:14 PM, TMFHousel wrote:

    NuvoRiche,

    Thanks for your comments. I think the main point of this article was simply to point out another way to look at bank stocks. Indeed, WFC is in much better shape than other banks, and I've pointed out the tax write-off, getting-paid-to-take-wachovia situation here:

    http://www.fool.com/investing/dividends-income/2008/10/21/wh...

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