The 2 Worst Cheap Bank Stocks Right Now

Source: Flickr

There is a big difference between a cheap bank stock, and a cheap bank stock worth buying. Many cheap banks will remain cheap for years -- these are value traps.

I've looked through many of the lowest-valued banks to find two of the worst -- two banks that are cheap and could remain cheap for years to come. Hopefully, this article will help you better understand the reasons why a bottom-quartile bank is given a lower valuation than its peers.

This isn't your financial ally
Spun-off from General Motors during the financial crisis, Ally Financial (ALLY -3.23%) is one of the largest automotive lenders in the United States. The company has relationships with 16,000 dealerships, writing loans on millions of new and used cars each and every year. It currently trades for 0.87 times tangible book value, according to S&P Capital IQ, making it one of the cheapest U.S. banks.

But Ally is cheap for a reason. It faces several competitive issues, stemming from a lack of low-cost deposits and growing competition in the American automotive lending business.

Let's start first with deposits. Ally Financial is, above all else, deposit starved. The company last reported that only 43% of its balance sheet liabilities were deposits. The rest is made up of short- and long-term debt -- the plague of any bank. After all, debt is much more costly than deposits.

But even the company's deposits leave something to be desired. Substantially all of its deposits are interest-bearing, and currently cost the company 1.31% annually. A major competitor, Capital One Financial, raises deposits at a fraction of the cost of Ally Financial -- it paid just 0.6% on its mostly online deposits as of its last quarterly filing.

Competitors are also taking greater share of the market. Ford has its own finance arm. General Motors recently purchased AmeriCredit, effectively repositioning itself in automotive finance. And traditional banks, which have bountiful cheap funding sources, have doubled down on autos. 

Ally Financial is a classic case in a bank stock being cheap, but for all the right reasons. Upside could come, but only if Ally can displace its long-term debt with deposits, a move that is taking more time than many would have expected.

When costs come into play
This California bank, like Ally, lacks in the deposit department. Meet Banc of California (BANC), a bank holding company that reports roughly 85% of its deposits are interest-bearing, and cost the company an average of 1.03%.

High-cost deposits are not necessarily a problem if a bank can cut costs elsewhere. Unfortunately, Banc of California's branch-based business model leaves much to be desired. It currently operates 17 branches in California, and 60 loan-production offices around the United States.

The company's last-reported efficiency ratio is an eye-popping 85%. Said another way, the bank doles out $0.85 in overhead costs just to generate $1 in revenue. Ideally, a bank's efficiency ratio would be somewhere in the range of 50-65%.

So how does Banc of California bring its high costs back down into reasonable territory? It remains to be seen.

Few levers to pull
After shifting to a bank holding company, Banc of California streamlined operations, reducing executive headcount between the banks under its umbrella. And the company has called for a total of $12 million in operating cost cuts, which, while significant, would keep operational expenses high as a percentage of revenue. Whether or not these cost cuts can materialize remains to be seen -- for now, they're pie-in-the-sky numbers touted by management.

Perhaps the most glaring underlying issue is one of market share. In markets where Banc of California is most competitive, it still fails to break into the top 15.

Source: Banc of California

Seeing as banking is a business which requires geographic dominance for a bank to operate with a low efficiency ratio, Banc of California's economics are built on shaky ground. And even with above-average utilization of its balance sheet -- financial leverage has averaged over 12 times -- the bank has wavered above and below profitability.

The stock price is a consolation, though minor. Trading at about 1.07 times tangible book value, according to S&P Capital IQ, it's one of the cheaper bank stocks on the market. But you'd have to bank on serious cost cuts to generate a substantial return -- after leveraging its balance sheet, cutting executive rosters, and streamlining operations, it has exhausted most of the levers on which it can pull.

If history is any guide, its consistently poor returns on equity (which have failed to breach double digits at any point in the last 10 years) suggest it will be a consistent underperformer.

The Foolish takeaway
In banking, and in most industries, a cheap valuation is only one part of finding a great stock. In most cases, banks, which are easily compared to one another, trade at a discount because of operational and competitive difficulties.

After all, banks sell a commodity -- money. A bank which pays the most for money to lend competes poorly with banks which generate billions in low-cost funding sources like savings and checking deposits. Ally Financial and Banc of California are two such banks that pay far too much for their funding to remain competitive against their peers.