"Be fearful when others are greedy and greedy when others are fearful." -- Warren Buffet

The financial sector is a scary place for Institutional investors. Banks are reorganizing business units, regulations are increasing, and the economy is weak. Luckily for you -- the individual investor -- the time is ripe. Banks still trade at all-time lows, but are much stronger than they were before the crisis. Before the financial sector becomes "hot" again, here are three signs you need to know to pick the best investment.

1. Price-to-book ratio less than 1
Financials were hit hard in the recession, and they have yet to bounce back completely. Since 2008, the Dow has lost 29%, while iShares Financial Index Fund has lost 38%! Though you might think institutional investors would jump at the chance to be greedy in a fearful market, that hasn't been the case. Many are still unsure how Dodd-Frank, the Volcker Rule proposal, and the fiscal cliff will affect banking's long-term profitability.

Yet one thing is for sure: On a price-to-book basis, banks look cheap.


US Bancorp(NYSE:USB)


Huntington (NASDAQ:HBAN)



Price-to-book ratio






Source: Google Finance.

Though many investors swear by analyzing the company's price-to-earnings ratio, smart investors understand that the price-to-book ratio is better for banks.

All companies borrow and raise money (liabilities) to make more money (assets). However, banks are special -- they don't invest their money into a tractor, furnace, or semiconductor factory. Banks borrow a dollar to lend that dollar out at a slightly higher interest rate. That means a bank's assets and liabilities are both cold, hard cash. And cash is more easily valued than a factory. Since book value is the difference between total liabilities and total assets, the price-to-book ratio is a better signal of a banks' value.

Now, analyzing the above chart, we can see that four out of the five featured banks seem like great deals. At a P/B ratio of 1.03, investors are paying for just $1.03 for every dollar of Huntington Banc's book value. That's like paying a baker $1.03 for a pie that cost $1 to make.

Better yet, three of the banks seem like complete steals! With a P/B ratio below $1, investors are paying just $0.78 for a $1 piece of Zions' pie.

2. Debt-to-equity less than 10, preferably lower
Of course, just because banks are "cheaper" on a price-to-book basis doesn't necessarily mean they're good buys. After seeing what happened to banks like Lehman Brothers during the financial crisis, it's best to stay clear of debt (for banks and in general). At one point, Lehman Brothers had a debt-to-equity ratio of 60 -- for every dollar of equity the company had, it owed $60 to its lenders.

The good news is that banks have gotten the message and have reduced their debt levels relative to their equity.

Source: Y Charts.

Right now, our five banks' debt-to-equity ratios are a third of their 2008 levels. And all are below the FDIC's debt-to-equity minimum of 10. (With that level of equity, commercial banks can still weather a bad loan or shrinking interest spreads).

With the exception of US Banc, these banks have decreased their levels of borrowing, and are financing their operations sustainably with equity.

3. Stable or increasing returns on assets.
Even if banks are cheap to invest in, and better positioned to profit thanks to better capital structure, the question still remains: Can these commercial banks actually make a profit?

To answer this, some investors may like to look at the return on equity (ROE) -- but it's not the best metric for banks. Because management can use debt to significantly boost ROE, I think return on assets (ROA) makes a better measure for evaluating management performance. And looking at the ROA over time is even better. It can reveal which companies are focused on quarterly profits as opposed to long-term profitability.

Source: Y Charts.

Looking at the chart above, commercial banks have recovered from their 2009-2010 dip. And some are better off than they were before the crisis. In 2008, Huntington had an ROA close to zero, but right now, it has a ROA of 1.02%. Because the financial sector is still in shambles, an ROA of 1% or higher is fantastic!

The Foolish bottom line
The financial industry seems to be in constant disrepair. Yet, these five commercial banks have shown that banking is getting better. All have improved their financing to rely less on debt, and management has stepped up and guided these banks past the financial crisis. With expectations low on a P/B basis, I think any one of these banks can weather the ensuing financial cliff and bring your portfolio huge profits.

However, if I were to choose just one bank, I would invest in Huntington Bancshares. Though its P/B ratio hovers above 1, the premium is very small -- you're paying just 3% more for an incredibly well-managed bank. Of the five, it's the only bank that has both a ROA over 1% and a debt-to-equity ratio less than 0.5.

If you'd like to learn more about the competitive landscape and how Huntington Bancshares is weathering our uncertain economy, you're in luck. The Motley Fool created a premium report, and we think that Huntington Bancshares is a buy. I invite you to read it now. For instant access, just click here!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.