For the first time since the great financial crisis, a crack in the banking structure has emerged, and we have seen -- so far at least -- three significant banks fail and be taken over by the FDIC, and one other bank voluntarily wind down its operations. In all, investors have lost hundreds of billions of dollars in market cap and are unlikely to see single penny once the final scraps are picked over.
As a result, most bank stocks have crashed. The SPDR S&P Bank ETF (NYSEMKT: KBE), a decent proxy for large U.S. banks, has lost more than 30% of its value from the 2023 peak, while the SPDR S&P Regional Banking ETF (NYSEMKT: KRE) has fallen almost 40% from its high.
Investors are scared to own banks right now. Ironically, history has shown us ample evidence that this is when investors should be buying banks.
A (very) brief history of the banking industry
I'm not going to bore anyone with too many words here; as Inigo Montoya said, there is too much. I will sum up. Banking is cyclical, leveraged, and heavily affected by factors completely out of banker's hands. Because of this, to paraphrase another quote -- this time from a banker, not a fictional character -- bank crises are something that happen about once a decade.
These moments of crisis can undermine the results of even the (formerly) best banks. It's a rare bank that has managers who can avoid the siren's call of (risky) growth when all their competitors are growing. It's even more rare for a bank to have those qualities in management for multiple decades.
Here's a chart to illustrate this reality. Since Jamie Dimon became CEO of JPMorgan Chase (NYSE: JPM), it's outperformed its four largest competitors (by assets) as an investment.
JPM Total Return Level data by YCharts
All four of Bank of America (BAC 1.59%), Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), and U.S. Bancorp (NYSE: USB) have gone through -- in some cases multiple -- CEO changes since Dimon became CEO. Several -- Wells and BofA in particular -- also dealt with major issues in the ensuing 18 years, some that cost investors tens of billions of dollars to resolve.
How buying banks in a downturn can result in huge wins
I'm going to egregiously cherry pick a date: March 9, 2009. This was the market bottom of the financial crisis. Here's how the same large banks have done since:
JPM Total Return Level data by YCharts
JPMorgan was still the best-performer with Bank of America a distant second (and the only other market-beater). But the key takeaway: Even down significantly from recent highs, every one has produced 10.8% or higher annualized total returns since then. That's exceptional, and better than the S&P 500's historical average returns. Even the worst performer, U.S. Bancorp, has earned more than four-fold returns.
The point: In March 2009 there were a lot of reasons to avoid bank stocks. A lot more than there are today, truth be told. But taking on the risk that things could get worse (which they did for BofA at least) before they got better can result in enormous gains, when Mr. Market is compensating you for that risk.
Why I'm buying bank stocks now, and three favorites
We are in some sort of a banking crisis. We may or may not see more midsize or small U.S. banks fail in 2023. Think about it this way; I have a mortgage with a 2.75% interest rate, and a high-yield savings account earning 3.75%. A bank can't survive paying $3.75 for money it's selling for $2.75.
Combine this challenge with rising worries that the commercial real estate market is about to implode, and there are plenty of fears that things could go from bad to worse for banks. Things may not be as scary as they were in 2009, but it's not great. And the market has discounted many bank stocks more than enough to compensate for those risks.
Here are three I like a lot right now.
Bank of America
At recent prices, shares trade for about 89% of book value; a 1.1x-1.3x book value premium is fair value in my book, considering its diversified mix of loans and the lowest-cost deposit base in banking. Brian Moynihan became CEO in 2010, and it took a few years to turn things around. Since 2012, BofA shareholders have enjoyed six-fold returns, and it's become one of the best-run banks in the world. Trading at a discount to fair value makes it an easy decision to buy.
Axos Financial
Axos Financial (AX -0.20%) is squarely in the midsize, regional bank crosshairs, with $19.8 billion in total assets. But while other smaller banks were losing depositors, Axos saw total deposits increase $1 billion in the first quarter of 2023. It also reported 33% higher net interest income and expanded its net interest margin to 4.4%. At 1.2 times book value, Axos isn't as cheap as Bank of America, but it's much faster growing, and trades for a premium because of its more profitable, asset-light business structure. Except for the early days of the Coronavirus pandemic, this is the cheapest Axos has been on a book value basis in 11 years.
Live Oak Bancshares
Like Axos, Live Oak Bancshares (LOB -0.54%) is even smaller, with $10.4 billion in assets. It also focuses on small business lending, and consumer savings for its deposit base. The vast majority of its deposits are consumer savings, checking, and time deposits (CDs), while most of its loans are commercial and industrial loans, the majority of which are adjustable rate. So even as deposit costs have increased, it is earning steadily more in yield from both new loans and its existing portfolio. Its business model is quite differentiated from most banks, and like Axos, it doesn't have high-cost branches, and it also has very few deposits above FDIC limits. At 1.2 times book value, this is about as cheap as shares have ever been. Live Oak is exceptionally well-run and built for conservative growth and high profitability.
Zig when markets zag (sometimes)
Usually, the best thing to do is whatever the market is doing. Stocks go up most years, so being contrarian is often a losing endeavor. But with banks, history tells us a different story: When the market is most fearful is often the best time to buy. I'm not just making that suggestion to others; it's advice I've already taken with my own funds.
