The Top 5 Banks to Own Now

Last week rounded out the earnings season for the top five U.S. commercial banks with reports from Wells Fargo and US Bancorp. Neither stock performed well on the week, and it's the  opportunity for patient investors to revisit a trade that I expect to be a big winner over the next 3 to 5 years.

Big banks are lagging
In fact, the largest U.S. banks have had a hard time of it since the beginning of March. The bank basket I originally highlighted at the end of November (JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo) is now underperforming the S&P 500, haven given up a 13 percentage point lead it had on the index in January (to track the updated basket in your watchlist, click here).

Expanding our bank basket
Today, I want to draw investors' attention to the valuations of this group (again) -- and I'm adding US Bancorp to the basket:

*Based on the consensus earnings estimate for the next twelve months. Source: Capital IQ, a division of Standard & Poor's. Both multiples are at Nov. 21, 2011.

Higher quality for a modest premium
Why am I adding US Bancorp? Parent to the fifth largest commercial bank in the U.S., the addition raises the average quality of our basket and adds some diversification in exchange for a modest premium in average valuation: The basket's price-to-book value multiple increases from 0.91 to 1.10, while the price-to-earnings multiple goes from 9.7 to 10.1.

Historically cheap
Is US Bancorp undervalued on a standalone basis? It is if we go by historical valuations. Prior to the massacre in bank stocks that occurred at the beginning of 2009, you have to go back to August 1995 to find the shares trading at a lower price-to-book value multiple. Wells Fargo is in a similar situation: At a price-to-book multiple of 1.26, you'd have look back before 1994 to find a lower multiple (I can't tell how much before, as my data begins in 1994). The same goes for Bank of America, except you'd need to go back before 1992.

JPMorgan Chase also looks cheap. Last week, The Wall Street Journal's "Heard on the Street" column argued that, in the context of slowing loan growth, Wells shares no longer warrant a premium book value multiple compared to JPMorgan. Even if we assume that's true, it's more likely that it's JPMorgan's shares -- which are now changing hands at book value -- that are undervalued, rather than Wells Fargo's that are overvalued.

The luster of Jamie Dimon at the price of coal
When bank shares trade at book value, there are two possible explanations: Either the book value is grossly overstated or the bank will never earn an economic return on its equity. Given that banks are now reversing reserves after having taken huge charges in the aftermath of the credit crisis, there is little reason to believe the former. And as far as JPMorgan being unable to earn an economic return? It's difficult to entertain that notion seriously. If one of the best-run banks in the world -- one of the great franchises of U.S. business -- can't achieve that, stock investors might as well throw in the towel immediately.

Why, then, are investors discounting these bank shares so heavily? Prem Watsa, CEO of Fairfax Financial Holdings (FRFHF.PK), offered one possible explanation at his company's annual meeting last week. In defending Fairfax's holdings of U.S. Bancorp, Wells Fargo, and other blue-chip shares, he said: "The underlying fundamentals are there for everyone to see, but it's boring. No one wants to buy something that will take five, six years [to double in value.]" If he's right, that's much higher than one can reasonably expect from the broad market, and at much lower risk.

At the end of 2010, Fairfax's positions in Wells and US Bancorp represented 9.4% of its total reported stock holdings. Watsa is a value investor who has modeled Fairfax on Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B). (Note that Warren Buffett also owns both banks in Berkshire's portfolio. In fact, Wells Fargo is Berkshire's second largest holding, after Coca-Cola.)

The cheapest oligopoly going
Banks still face some regulatory uncertainty regarding some of the fees they are able to charge their customers, and that may be part of their undervaluation. However, the flip side of that coin is that -- far from reducing the influence of too-big-to-fail banks -- the response to the financial crisis has increased the power of this banking oligopoly. That might be bad news for taxpayers and banking customers, but it has created a huge opportunity for bank share investors, who can buy a good ol' fashioned oligopoly at knockdown prices.

Warren Buffett and Prem Watsa own U.S. Bancorp and Wells Fargo shares; they're putting their money where their mouth is. Find out the 5 Stocks The Motley Fool Owns -- And You Should Too.