Here's a stock tip you can take to the bank: Never buy shares in a second-rate lender. If you're interested in this sector, stick to banks that are tried and true like M&T Bank (NYSE: MTB ) or New York Community Bancorp (NYSE: NYCB ) .
If you want to be a good investor -- and I mean really good -- then you have to use time and the law of compounding returns to your advantage. Take the following chart as an example of how these forces of nature work in a prudent investor's favor.
Easy enough, right?
The problem is that getting from point A to point B is easier said than done when it comes to bank stocks. Beyond the litany of behavioral biases and emotional barriers that stand between you and quadruple-digit returns, the business model of any particular bank is highly volatile and subject to impairment if not outright failure in the intervening time period.
Just this week, The Wall Street Journal reported on the declining number of banks in the United States. "The number of banking institutions in the U.S. has dwindled to its lowest level since at least the Great Depression," the paper observed.
According to data from the Federal Deposit Insurance Corporation, an estimated 10,000 lenders have vanished into thin air since the mid-1980s. That equates to 55% of the previous peak, 17% of which were the result of failure. These are startling statistics, but what's more disturbing is that they understate the damage done to the industry and, specifically, equity holders.
Of the banks lucky enough to survive the last crisis, many were obliged to dramatically dilute existing shareholders. Huntington Bancshares (NASDAQ: HBAN ) and Citigroup (NYSE: C ) serve as prototypical examples. Since the beginning of 2007, Huntington Bancshares' outstanding share count has more than tripled while Citigroup's increased by a factor of five. The net result was that shareholders saw their stakes in the businesses eviscerated.
All of this boils down to one thing: While banks seem like stodgy deposit-takers and prudent risk managers, the reality couldn't be further from the truth. By their very nature, banks are highly leveraged financial institutions that hold illiquid assets. On top of this, while virtually every banker claims to take risk management seriously, very few actually do when it matters most.
"I will tell you what we have been telling you for the past three years, which is we certainly don't expect credit to be better from here," said a top executive at Citigroup in October of 2006. "We plan for it to be worse from here, and we watch it just as closely at Citigroup as you would hope, as the owners of the company, that we do."
Okay, so maybe she was overstating their vigilance a bit. With the benefit of hindsight, we know this was an egregious misrepresentation, if not an outright lie.
The retort for investors who nevertheless like bank stocks is simple: Only invest in the best. There are very few circumstances under which I'd recommend investors buy any bank stock other than the four I've identified in the past: Wells Fargo, U.S. Bancorp, M&T Bank, and New York Community Bancorp.
The leaders of these institutions are the real deal. They understand that growing revenue is easy, but managing credit is hard. They do more than simply talk about responsible leadership; their actions (and results) back it up. And, perhaps most importantly, they've made long-term shareholders rich over multiple decades and through numerous cycles.
You want to own bank stocks? Own these. Forget the rest.
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