By "investment-grade," I'm referring not to large financial companies' credit ratings, but to their suitability as long-term stock investments -- or lack thereof. One large U.S. hedge fund manager considers these giants "uninvestable," recently writing to his investors that "we are done for the foreseeable future investing in large, complicated financial institutions." Unfortunately, after examining the six largest U.S. banks, I'm inclined to agree.
Investment banks: Goldman Sachs
I've written several times that the common stocks of investment banks are unfit as long-term investments. My primary argument has nothing to do with leverage, derivatives, or proprietary trading; these firms simply aren't run for the benefit of outside shareholders. Employees siphon off the lion's share of the profits, leaving public shareholders with crumbs that do not compensate them for the risk they bear.
Both stocks may constitute short-term 'value plays' at one time or another, in which an investor's expected gains are predicated on the shares' return to a 'normal' valuation after a temporary mispricing. However, the success of any long-term stock investment depends on the underlying economics of the business. For an investment bank's shareholders, those odds are clearly unfavorable.
Universal banks: JPMorgan Chase
Universal banks suffer from the same problem as investment banks, to the degree that they have large investment banking operations. In addition, the absurd breadth and complexity of these organizations raises serious doubts about executives' ability to manage them effectively. Finally, these three organizations represent the pinnacle of the absurdity that is "too big to fail." In theory, that status is a license to print money. In practice, it is a source of massive instability -- one I don't expect regulatory overhaul to address effectively.
There is undoubtedly a difference in quality between these three firms, with JPMorgan head and shoulders above the other two. I prefer to err on the side of caution in these matters. Thus, while you can certainly 'rent' any of these stocks if you spot a significant mispricing and a catalyst that will nudge the shares back to fair value. But as long-term investments, you're better off avoiding these companies.
The exception that proves the rule: Wells Fargo
Wells Fargo is the only bank among these six organizations that has a singular focus on traditional bank lending and a proper regard for its shareholders. Management is more conservative than at the other banks I have described above, and it behaves as if the organization is operating without a safety net. In light of these characteristics, I believe Wells Fargo common stock is suitable as a long-term holding (at a reasonable price, of course).
Don't bank on financial reform
Once financial reform passes, investors may feel more comfortable wading back into bank stocks. However, I would suggest that adding regulation to one of the most highly regulated industries in the economy is no panacea. The best protection for investors involves a pointed assessment of whether these organizations and their managers responsibly and competently handle the shareholder capital with which they're entrusted.
By distorting the pricing of risk, the Federal Reserve is creating new perils in U.S. stock and bond markets. Thankfully, there are other venues for your assets. Tim Hanson highlights the top markets right now.
Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.