The Bank You Need to Buy

As the Fool’s banking editor, I spend a LOT of time looking into banks.

Now, I’ll admit that far too much of my time has been spent reading about Goldman Sachs (NYSE:GS) conspiracy theories, excessive CEO pay, and the latest bailout acronyms.

But I do pore through enough bank financials, press releases, and analyst projections to make a Wall Street intern cry.

By popular demand, I’ll use my inability to escape banking drama to satisfy your bank lust. If you read on, I’ll give you my current best bet in the banking sector.

The ideal bank
To know when you’ve got a good bank, you have to know what an ideal bank looks like.

Banks should be pretty simple businesses. They offer to keep depositors’ money safe in return for the right to lend that money out until needed. The banks make their money by charging higher interest rates for the money they lend out than they pay their depositors. They can charge these higher rates because they are taking on the risk that their borrowers will default on their loans, which can vary from residential mortgages to credit card loans to commercial loans. Because the ideal bank is a pretty stable institution, it can pay a healthy dividend to its shareholders.

What happened?
As you know, this model was utterly bastardized in recent years. You’ve heard it all before, so I won’t rehash too much. Basically, these once-boring institutions started playing with exotic derivatives instruments that fooled them into thinking they could offer loans at extraordinarily low interest rates and still make a profit.

They were wrong.

Picking through the wreckage
It’s never good to buy any stock based on five minutes of research, but banking punishes lax research even more than other sectors. For example, buying consumer goods companies like Coca-Cola (NYSE:KO) or Procter & Gamble (NYSE:PG) on a P/E and a prayer is much less likely to destroy your returns than picking a bank based solely on the price-to-book ratio.

Picking a great bank investment has only gotten more complicated, but luckily the same things that made a bank attractive decades ago still apply today:

• Earnings power.
• Balance-sheet strength.
• Price.
• A sustainable dividend.

Based on these criteria, we can quickly eliminate a lot of banks.

If a nice, fat dividend is what you’re seeking, the big banks are not where you want to be. The big guys all slashed their dividends to hoard capital and speed their way out of the government’s TARP program. You’ll recall that participation for the biggest of the big was mandatory.

Even if you’re willing to forgo a large dividend, all the big banks have earnings power, balance sheet, or price problems. Pick your poison:

• Investment banking business models that haven’t learned from the financial crisis (Goldman Sachs, JPMorgan Chase (NYSE:JPM), and Morgan Stanley).
• Balance sheets that still require massive government assistance (Citigroup (NYSE:C) and Bank of America (NYSE:BAC)).
• Large balance sheet exposure to commercial lending (PNC Bank).
• Valuations that already factor in relative quality (Wells Fargo (NYSE:WFC) and US Bancorp).

With no screaming values among the large banks, it’s the regional and community banks that are the most attractive these days.

Small is the new big
I’ve been highlighting the opportunity in small banks for a few months now. What I love about the small banks is that it’s possible to find banks low on derivatives exposure and high on asset quality. Banks that simply take deposits, make loans, pocket the interest rate spread, and regularly return cash to shareholders via dividends. In short, we can find banks that approach the ideal bank I described earlier.

Here are three small banks that top the charts on earnings power (positive net income and reasonable net interest margins), balance sheet strength (high reserves versus their nonperforming assets), price (low price-to-book value ratios), and dividend yield:

Source: Capital IQ, a division of Standard and Poor's. Financials are updated through Q3 of 2009.

Digging in a little further, United Bankshares and First Niagara are heavily weighted (around half of all loans) in commercial lending. Also, United’s reserves are a bit low for my taste, and First Niagara received TARP funds (but has since paid them back).

Meanwhile, the upstate New York-based Community Bank System has its loans equally spread among residential, commercial, and consumer loans, maintains strong reserves, and hasn’t taken any bailout funds.

I first highlighted this bank in a column back in May and bought shares back in July. Community Bank System is up about 20%-30% since those dates, but I believe it’s worth your time to research it further at today’s prices. If prices fall a little, even more so.

If you need to buy a bank, Community Bank System is one you should consider.

Of course, the beauty of the stock market is you don’t need to buy any stock you’re not comfortable with. If banking isn’t within your circle of competence, but you still want to make individual stock picks, you can search any of the other sectors for bargains.

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Anand Chokkavelu owns shares in Community Bank System and long-held shares of Citigroup. Coca-Cola is a Motley Fool Inside Value recommendation. Coca-Cola and Procter & Gamble are Motley Fool Income Investor picks. The Fool owns shares of Procter & Gamble. The Fool has a disclosure policy.