After the market closes, I usually scan a list that shows me all of the stocks that have hit 52-week lows. Lately, that list has become dominated by banks, and I'm fairly certain that more banks are hitting lows right now than are companies in all other industries combined.
It's not hard to figure out why. Banks make most of their money by collecting the difference between what they have to pay depositors and what they receive from borrowers by lending out to homeowners, consumers, and businesses. Deposits are short-term funds because depositors can demand their money back whenever they want. On the other hand, loans tend to be longer-term assets, such as 30-year mortgages.
As a result, banks are struggling with the flat yield curve as short-term rates increase (partly because depositors are shifting to higher-yielding CDs and online money markets) and long-term rates decrease (partly because an excess of liquidity has pushed risk premiums to unsustainably low levels).
That said, although this isn't an all-inclusive list, here are a few things investors might want to look for when they go bottom-fishing for banks.
1. Low price-to-book multiple
Berkshire Hathaway's 1978 annual report describes Warren Buffett's penchant for buying shares below book value:
Yet our purchase of SAFECO was made at substantially under book value. We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation -- with necessarily uncertain prospects -- at less than 100 cents on the dollar.
A great example of a low price-to-book-multiple bank is Mercantile Bank
2. Small deposit premiums/high deposit quality
Deposits are a bank's lifeblood. Because the FDIC guarantees deposits, and because depositors regard banks as safe and convenient, even a mediocre bank can borrow at a cheaper rate than can the bluest of the blue chips. Thus, deposits are extremely valuable.
A bank's deposit premium is generally calculated as such:
(market cap - tangible book value) / deposits
The deposit premium is meant to capture the portion of a bank's market value attributable to the value of its existing deposits. Obviously, the lower one pays, the better.
The quality of a bank's deposits is extremely important as well. A bank with a lot of non-interest-bearing deposits is clearly more valuable than a bank with a lot of high-cost brokered CDs. Commerce Bancorp
3. Earnings yield
A high earnings yield, the inverse of a price-to-earnings ratio, is equivalent to a low P/E multiple. I would consider anything in the range of 8% to 12% or more fairly attractive. This point is fairly self-explanatory, so I'll move on.
4. Non-interest income
Banks make money off interest rate spreads -- the difference between the cost of funding and the earning asset yield -- and also from fee income. The latter might come from credit card payment processing, deposit overdraft fees, or investment management revenue. But the key is that fee income isn't as subject to the whims of the interest-rate curve and helps diversify a bank's income streams.
Some banks with very healthy mixes of fee income include PNC
5. Credit quality
A bank that makes too many bad loans won't be in business for very long, so credit quality is crucial. A good way to judge a bank's credit quality is to look at its long-term charge-off rate -- a measure of the portion of loans that are uncollectible. One could also look at the types of loans a bank is making. If the bank practices "extreme lending," such as hybrid interest-only and negative amortization mortgage loans, or high-loan-to-value land development or condo conversion loans, that's probably a pretty clear sign that the bank's credit quality will deteriorate.
The efficiency ratio is my favorite metric for banks. It measures non-interest expenses as a percentage of revenue. A low efficiency ratio is a very good indicator that a bank runs a tight ship and isn't wasting shareholder money. Return on equity and return on assets also measure a bank's efficiency. Anything above 15% for ROE and 1.5 for ROA could be considered very positive.
Good luck, and happy hunting!
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- US Bancorp's Masked Momentum
- Warren Buffett's Priceless Investment Advice
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates hearing your comments, concerns, and complaints. Berkshire Hathaway is a recommendation of Motley Fool Stock Advisor and Motley Fool Inside Value. The Fool has a disclosure policy.