Time to Buy the Banks, but Which Banks to Buy?

In last week's "Is It Time to Buy the Banks?" I looked at evidence suggesting the banking sector may be ripe with interesting investment opportunities. In the second installment of this two-part article, I'll take a look at which banks investors should be focusing on to achieve superior returns.

In case you haven't read (or don't want to read) the first part, let me give you a little anecdotal evidence to support my thesis that the U.S. banking sector is a rich hunting ground for investors: I can rattle off multiple references to exceptional investors that have stated it.

This is "innocent money"!?
Only last week, an official from Temasek, an investment arm of the Singaporean government, said: "We recently concentrated on U.S. and UK [financial services] primarily because we see value." Temasek owns 9.4% of Merrill Lynch (NYSE:MER).

Warren Buffett can dismiss sovereign wealth funds as "innocent money," but Temasek has achieved 18% annualized returns since 1974 – those are hardly the numbers of a lamb to the slaughter!

With that said, let's examine the current valuations of two groups of stocks in historical context. I've got three "good" banks that have fared rather better than their peers during this credit crisis: BB&T (NYSE:BBT), M&T Bancorp (NYSE:MTB), and Wells Fargo (NYSE:WFC). And three "bad" banks that have had a dreadful time of it: (Citigroup (NYSE:C), Wachovia (NYSE:WB), and Washington Mutual (NYSE:WM).

*Prior to the start of the credit crisis. **Low for available data beginning on 01/01/1992. *** Low since 01/01/1993. ****Low since 01/01/1994.
Source: Capital IQ, Yahoo! Finance.

There are a couple of things that jump out from the table: First, one has to go back almost 14 years to find book value multiples as low as they are currently. In addition, the lows are tightly grouped -- within a 45-day period at the end of 1994 for five of the six stocks.

What happened to bank stocks in the fourth quarter of 1994?
For the whippersnappers out there, here's a market history recap: In 1994, the Fed instituted a series of unexpected rate hikes, sparking heavy selling in bank stocks. Higher rates mean higher funding costs for banks. Investors were concerned their margins would be squeezed. Market sentiment toward banks was very negative; valuations were depressed.

Since then, our three good banks have easily outperformed the KBW Bank Index and the S&P 500 by an average of 8.5% and 8% on an annualized basis, respectively.

(Note that the stated outperformance is inflated due to the fact that the annualized returns calculated for the KBW Index and the S&P 500 do not include dividends. Even if we generously assume average dividend yields of 5.5% and 4% for the KBW Bank Index and the S&P 500, respectively, the margin of outperformance remains impressive.)

Furthermore, I calculated outperformance over a trough-to-trough period. The numbers would surely be even more impressive if bank stocks were not currently depressed.

On the other hand, our bad bank sample has performed disastrously, losing an average of 2.8% and 3.5%, respectively, to the KBW Bank Index and the S&P500 on an annualized basis. (Citigroup is the standout in the group, more on this later.) Note that in this case, accounting for dividends would produce a margin of underperformance that is even greater, not smaller, than my figures show.

Things look pretty clear cut -- is it really that easy?
The data appear to paint an obvious picture: "Buy the 'good' banks; sell the 'bad' ones." But let's be mindful of look-back bias: Do the banks in each set really share anything beyond their performance in the current environment? Would we have grouped them in the same way at the end of 1994?

I submit that there were objective elements that might have enabled investors to sort these banks into two groups in 1994 -- or at the very least identify the good ones. Banks in our first group are regarded as well run, conservative lenders. The second group might also have been described as well run ... in good times. However, they simply don't have the same culture of prudent lending and risk management.

Even the best performer among our bad banks was in grave difficulty only a few years earlier due to poor lending practices. In 1990 and 1991, Citicorp (the predecessor entity to Citigroup) was faced with severe losses on loans, including $13 billion in commercial real estate loans, more than a third of which were concentrated in the western United States. By 1991, 40% of the real estate loans were nonperforming.

Urged by the Fed to strengthen its capital position, the bank sought fresh capital, including $590 million from Saudi investor Prince al-Waleed bin Talal in February 1991.

The only competitive advantage a bank will ever have
Lending discipline, fostered by a strong culture and adequate processes, is perhaps the only sustainable competitive advantage in banking -- something that is poorly understood by many investors. Capital is fungible, and neither technology, nor innovation provides a durable advantage. (In fact, I'd be a little skeptical of banks that are always at the forefront of the industry; some banks can be too innovative for their own good.)

Of course, institutions can change over time. In the years after World War I, for example, "Washington Mutual had a hard earned reputation as one of the strongest and most fundamentally sound savings and investment institutions in all of Washington State." Simply buying bank stocks that have performed well over the previous credit cycle won't do the trick -- one must ensure that lending discipline remains rock solid (for starters).

Banks have done gangbusters since mid-July -- am I too late?
Since their July 15 lows, banks have staged a huge comeback rally: The KBW Bank Index is up more than 35% since then. The mid-July period was undoubtedly an extreme buying opportunity, and investors who didn't take advantage of it may be convinced that they've missed the boat.

That could well be the case if your time horizon is measured in months. If, however, you can extend it out to 10 years and longer (which you should do if you are thinking of investing in stocks at all), our table suggests there are still some excellent opportunities left in the sector. In my judgment, all three of our "good" banks are likely to outperform the sector and the overall market over the next 10 years.

Going back: Buffett on Wells Fargo
I'll leave you with an excerpt from Berkshire Hathaway's 1990 letter to shareholders. Here, Warren Buffett describes the environment in which he made a massive purchase of Wells Fargo shares (Berkshire is Wells Fargo's largest shareholder):

"Our purchases of Wells Fargo ... were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted."

Does that sound familiar?

Related banking Foolishness:

• Bank Losses: Are We Just Getting Started?
• Financial Investors' Dream Stocks
• Is Wells Fargo on the Prowl?
• Is It Time to Buy the Banks?