Watch stocks you care about
The single, easiest way to keep track of all the stocks that matter...
Your own personalized stock watchlist!
It's a 100% FREE Motley Fool service...
Are bank stocks cheap?
By one measure, they sure look that way. And if you're a "value investor," for example, a disciple of Benjamin Graham and Warren Buffett, and an aficionado of buying stocks at a discount to their book value, you're probably feeling tempted to hop on the banking train. Tempted to bet that concerns over Europe are overblown, and that once this crisis blows over, banking stocks will bounce right back.
Don't judge a book value by its cover
Right now, stocks of most major U.S. banks sell for sizable discounts to their book value. In fact, only the Buffett-blessed Wells Fargo (NYSE: WFC ) currently costs more than its own net asset value. And I admit, some of the valuations we're seeing today seem very attractive:
|Goldman Sachs (NYSE: GS )||0.7|
|JPMorgan Chase (NYSE: JPM )||0.7|
|Morgan Stanley (NYSE: MS )||0.5|
|Citigroup (NYSE: C )||0.5|
|Bank of America (NYSE: BAC )||0.3 (!)|
When you consider that the average stock trading on the Dow Jones Industrial Average (INDEX: ^DJI ) costs not less than its book value, but 2.5 times its book, investing in banking stocks seems almost a no-brainer. But that's just the problem. Buying banking stocks today is not something you want to rush into without thinking.
It depends on what the meaning of "are" is
Are banks cheap? Are they -- as the above table certainly makes it appear -- so cheap that it's now ridiculously easy to make money by investing in them? If this were a simple matter of "buy at 0.5 times book value, wait until the stock rises to the average Dow valuation of 2.5 times book value... and collect a 400% profit," then the answer would clearly be yes.
But consider: What is it really that goes into a bank's book value that makes the company's net asset value look so high while its stock price is so low? Net asset value, as you know, is what you get if you take a bank's assets and subtract its liabilities. Therein lies the problem -- those "assets" may not be all they're cracked up to be, and those "liabilities" may be greater than they seem.
Danger in the details
Last week, Goldman Sachs shares dropped below $100, and Morgan Stanley suffered a one-day 9% drop on fears these banks had "exposure" to European sovereign debt, which could default. To allay such fears, Goldman, Morgan Stanley, and B of A and JPMorgan, too, published details on their lending to Portugal, Ireland, Italy, Greece, and Spain -- Europe's so called "PIIGS." The upshot of the reports was that while the banks had about $70 billion in combined exposure to troubled government debt, their net exposure was only about $40 billion.
How does that work?
Consider: When a bank issues a loan -- for example, by buying $1 million worth of Greek government bonds -- it's entitled to repayment of that $1 million plus interest. As you may have heard, though, there's a certain non-zero chance that Greece will default on its bonds. To mitigate this risk, many banks buy insurance against the risk of Greece defaulting on its loan, a credit default swap, in which they pay "some anonymous person" (SAP) a fee in exchange for a promise that if Greece does default on its bond, the SAP will make good on the debt.
Result: The thus-insured bank gets to book the value of the bond, minus the small fee it pays this poor SAP, as its asset value.
And here's where things get dicey. Sure, if everything goes as planned, the calculation is accurate. The bank's "book value" is what it says it is. But what happens if something goes wrong? What happens if, for some awful reason, the SAP who sold the bank a CDS turns out to be too poor to pay up? What if said SAP turns out to be named AIG? Or Lehman Brothers? Or... MF Global?
Alternatively, what if the European government in question works a deal with the EU to arrange a voluntary "haircut" on the value of its debt, such that no "default" technically takes place, and the CDS that the bank purchased never kicks in?
Why, in that case, dear Fool, it's not the poor SAP left holding the bag, but the supposedly smart bank that bought the CDS. In that case, the bank's asset is worth far less than the bank says it is. The bank's book value isn't what it says it is -- and the bank's stock isn't a cheap as we think it is.
Tired of investing in things that are way too complicated to understand -- and as we've seen today, no one else really understands, either? Get back to basics, Fool, and try investing in the tried and true. Read the Fool's new -- and free! – report, "The Only Energy Stock You'll Ever Need."