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:

Bank

Price-to-Book Value

Price-to-Earnings*

Bank of America (NYSE: BAC  )

0.58

9.25

Citigroup (NYSE: C  )

0.78

10.6

JPMorgan Chase (NYSE: JPM  )

1.03

8.8

US Bancorp (NYSE: USB  )

1.73

11.0

Wells Fargo (NYSE: WFC  )

1.26

10.1

Basket (Equal-weighted)

1.10

10.0

*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.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter.

Berkshire Hathaway is a Motley Fool Inside Value selection. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Bank of America, Berkshire Hathaway, JPMorgan Chase, and Wells Fargo. Through a separate Rising Star portfolio, The Fool is also short Bank of America. Alpha Newsletter Account, LLC owns shares of Fairfax Financial Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (23)

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 April 26, 2011, at 4:10 PM, ronbeasley wrote:

    Paying attention to Buffett and Watsa just makes sense. Wells Fargo is selling at the lowest valuation I have seen since 1992. It has enormous earnings power on its balance sheet, and is an extremely attractive opportunity here. WFC is the largest equity holding in my personal and client portfolios.

    Ron Beasley

    www.rwbi.net

  • Report this Comment On April 26, 2011, at 4:51 PM, buffalonate wrote:

    I agree. The American Bankers Association has said that loan defaults are falling across all 8 categories. Their 1 credit ratios have been going up across the board for banks. Every large bank I can think of has recently become profitable. I think there is very little risk in owning them and a lot of reward. Many large banks are at 3 month low so I have been stocking up on all of the large banks the last few days. First Niagara Financial Group is my favorite bank. It has remained profitable though the crisis and has doubled its bank branches through acquisitions in the last couple of years.

  • Report this Comment On April 26, 2011, at 5:16 PM, midnightmoney wrote:

    Shall we revisit the halcyon days of 2009, all the fear and loathing and panic, and ask ourselves why we haven't shed our caution as if it were just another layer of dispensable snake skin? Shall we go stand under the giant dagger disguised as a question mark that loomed over head for two years making they funny honing and oddly forgettable guillotine-like noises. It's still there, just this side of the horizon, tethered by lines of fear and disgust and utter exasperation and eviscerated lives and ruined retirements and foreclosures as if they were made on assembly lines. Oh yeah, that's right, foreclosures actually were made on assembly lines. Let's get out the brasses and woods and play something catchy, a knee-slappin' jig, shall we--something to bring bring back the bygone high days of robo-signing revelry?

    Naw, let's brush that under the rug as if it never happened and stand here wondering why no one has come back to the banks, holding out their money in trust and anticipation. Better yet, let's call the banks boring.

  • Report this Comment On April 26, 2011, at 6:10 PM, marc5477 wrote:

    ..Why? They gambled once and they will do it again if given the chance plus they are getting tighter regulation (which they should because they are crooks).

    Want an excellent bank?

    Check STD:

    Very Low PE

    High yield with incredible coverage

    Diversification into many countries

    Not a single losing quarter even though the crisis in '08/'09

    Excellent balance sheet

    STD is by far my top pick.

  • Report this Comment On April 26, 2011, at 6:43 PM, TimoDOZ wrote:

    Wow nice move in VLY!!!!

    Gotta love it!

    The ghost of "MAD" Anthony Wayne making the dead beat borrowers offers they can't refuse.

    It's pay what you owe or end up buried in the gardens of the Van Jack the Ripper Chopper House. By the time they dig you up, you are going to smell worse than a two week old Tuna Fish that Died sandwich. Or you could end up wearing seement galooshes at the bottom of the Pint View resevoir. AKA Lake Cyanamid. Very effective loan loss control leading to great rewards to shareholders. Go Bears!

  • Report this Comment On April 26, 2011, at 7:13 PM, xetn wrote:

    I guess you are assuming that the Fed will continue to bail out these banks in the future. FWIW, about the only thing holding them up now is the the phony reserves the Fed created out of thin air. And there are literally hundreds of thousands of foreclosed homes sitting on their balance sheets because of the problem with "who actually holds title" caused by Mortgage Electronic Registration Systems (MERS).

  • Report this Comment On April 26, 2011, at 7:30 PM, tdmlwh wrote:

    Worried banks are going to play games with the stock price and shares outstanding. Thus you end up holding shares for years waiting for a double and end up getting jack. For instance when there is a 10 for 1 reverse stock split eliminating the chance for lots of dividens in the future (b/c you have less shares) and eliminating the chance of going from $5 to $50 per share. Instead you are left with less shares for dividends and having to count on the share price going from $50 to $500 per share (far less likely in my opinion).

  • Report this Comment On April 26, 2011, at 7:34 PM, LeNagus wrote:

    Why US banks. Many have legal problems yet to be resolved. Many are still holding onto inflated houses which lay vacant, For me, I think the Canadian banks are the place to be. None of the problems mentioned above. And a country rich in natural resources. Now which one? Ideas anyone.

  • Report this Comment On April 26, 2011, at 7:50 PM, soycapital wrote:

    I hold Canadian banks but they are up %70-%100. I'd like to buy more but won't here, should have on the way up! HBC, USB, BNY are on my watch list along with WFC and STD. Room to rise.

  • Report this Comment On April 26, 2011, at 8:38 PM, Notwage wrote:

    If you have a short memory, don't pay attention to anything related to history, or have never read "The Black Swan" by Nassim Taleb, then you probably see no problem with investing your money into a Wall Street bank.

  • Report this Comment On April 26, 2011, at 8:49 PM, TMFAleph1 wrote:

    @Notwage

    I read 'Fooled by Randomness' before it was even published. Taleb posted the chapters on his website before he had found a publisher.

    Alex Dumortier

  • Report this Comment On April 27, 2011, at 9:57 AM, wasmick wrote:

    @xetn, "I guess you are assuming that the Fed will continue to bail out these banks in the future. FWIW, about the only thing holding them up now is the the phony reserves the Fed created out of thin air. And there are literally hundreds of thousands of foreclosed homes sitting on their balance sheets because of the problem with "who actually holds title" caused by Mortgage Electronic Registration Systems (MERS)."

    I'd love for you to back up some of your more amusing declarations - like this one - with facts.

    Anything, just anything at all that could masquerade as data would welcome.....exceedingly unlikely apparently......but welcome nonetheless.

    I'll wait here.

  • Report this Comment On April 27, 2011, at 1:30 PM, Duke5343 wrote:

    WAIT on Citi until after may 10-1 reverse split??? Stock could drop to $30 after split

  • Report this Comment On April 27, 2011, at 4:22 PM, TMFAleph1 wrote:

    @Duke5343

    Rest easy -- stock splits or reverse splits have zero effect on stock values.

    Alex Dumortier

  • Report this Comment On April 27, 2011, at 4:29 PM, wasmick wrote:

    @Duke5343,

    I doubt this comment: "WAIT on Citi until after may 10-1 reverse split??? Stock could drop to $30 after split" was a reply to mine, but since xetn is clearly in no position to defend his position, I'm just confirming that you're too smart to attempt to do so on his behalf.

  • Report this Comment On April 29, 2011, at 11:30 AM, 4spiel wrote:

    I admit the euro is high and that Spain has mortgage problems but I think Santander is a good bank to have a little long term

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1481972, ~/Articles/ArticleHandler.aspx, 11/27/2014 2:45:21 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement