The StressTest column appears every Thursday on Check back weekly and follow @TMFStressTest on Twitter.

"Buy bank stocks below book value and sell above twice book value." That's about as simple as it gets when it comes to investing in bank stocks. It's also dangerous advice.

I'm a fan of simplicity. William of Ockham (yup, the Ockham’s Razor guy) was a bright chap, and I'm always on the lookout for ways to strip unnecessary work from my investing process. But I'm also a fan of data, and if the simple solution doesn't pass the test of real-world use... let's just say there are plenty of trash cans available. 

The baseline
My time frame for this little experiment was a decade -- specifically, mid-year 2003 through mid-year 2013. I allowed for portfolios to be changed twice per year -- once at the beginning of the year, and again at the middle of the year. And I compared three separate returns results: Those of the S&P 500 (SNPINDEX:^GSPC), the 10 largest banks, and the 50 largest banks.

For a starting point of our journey, we can look at the returns of all participants for all groups. Here's how that pans out:

Group 2003 to 2013 Return
S&P 500 77.8%
Top 10 banks (15.5%)
Top 50 banks (16.7%)

Source: S&P Capital IQ, author's calculations.

Banks have underperformed over the past decade. Probably not all that surprising. But what we want to know is how much better we could have done by following the advice of buying below tangible book value, and selling above two times tangible book value.

The answer: Still pretty ugly
Once we set the parameters to only "buy" a stock under book, hold it between one and two times book, and "sell" at above two times book, the results change noticeably.

Group 2003 to 2013 Return
S&P 500 77.8%
Top 10 banks 6.7%
Top 50 banks (30.3%)

Source: S&P Capital IQ, author's calculations.


Although the results from the top 10 banks improved to a gain over the period, the loss from the top 50 got much worse. And since the group of 50 is our larger sample size, we're going to want to pay more attention to that.

You don't have to dig too far into the numbers to figure out why we get these results despite following the "classic" bank-investing strategy. In the pre-crisis era, banks were trading well above tangible book value. Bank of America (NYSE:BAC), for instance, was fetching 3.8 times its TBV as of early 2005, while Citigroup (NYSE:C) and US Bancorp (NYSE:USB) traded at multiples of 4.4 and 4.9, respectively. So, while times were good, you wouldn't have owned bank stocks.

It wasn't until the crisis deepened considerably, and bank results deteriorated significantly, that the opportunity arose to buy at prices below tangible book. At the beginning of 2009, Citi could be bought at a P/TBV of 0.9. Similarly, SunTrust (NYSE:STI) and KeyCorp (NYSE:KEY) -- both just outside of the top-10 largest banks -- could have been picked up at prices below tangible book value.

The problem with that, though, is that if you jumped in then, you were jumping in on some of the most troubled, weakest banks. If you bought Citi in January of 2009, you would've lost 61% in the six months that followed. SunTrust and KeyCorp would have both set you back more than 40%. That's a drop that's tough to come back from.

Buy the bad, avoid the good
This trusted bank-investing strategy is almost completely backwards. It essentially directs you to buy the worst banks, at the worst times, and avoid the well-run banking institutions that you'd actually want to own. 

Over the time period of my data set, Wells Fargo (NYSE:WFC) and US Bancorp were some of the best-performing bank stocks. That shouldn't be too surprising, because they're also two of the best-run big banks. But you never would have owned them because they never traded anywhere below book value. 

In no universe does this actually seem like a good strategy.

A better way to go
Don't worry, I didn't plan to leave you without any measuring stick to replace the one I just blew up.

My tweak to the rule is really quite simple. In short, it's looking for banks that are actually profitable to a reasonable extent. Not exactly rocket science, right?

Specifically, I added a requirement that the banks we're buying have an effective return to investors (EROI) of at least 5%. What I mean by "effective" return to investors is the result you get when you divide the bank's return on equity by the price-to-tangible book value multiple.

Here's what happens to the returns of the data set when we add that requirement of a 5% EROI to the "classic" valuation multiple rule.

Group 2003 to 2013 Return
S&P 500 77.8%
Top 10 banks 140.8%
Top 50 banks 134.4%

Source: S&P Capital IQ, author's calculations.

That's more like it.

As you might guess, thanks to the now much-more-stringent requirements we've put on the "purchases," when using this modified rule, you'd only end up rarely investing in banks. And because there are so few observations here, the results could be a fluke.

Making it simpler
I figured it would be worth exploring what would happen if I tried loosening the filter and making the new rule a little simpler. 

Here's what happens if we forget worrying about the "below book / above twice book" rule at all, and solely focus on banks that had that effective return to investors of 5% or better.

Group 2003 to 2013 Return
S&P 500 77.8%
Top 10 banks 115.9%
Top 50 banks (10.2%)

Source: S&P Capital IQ, author's calculations.

Obviously, these results aren't exactly what we're looking for. The largest 10 banks still performed well, but the group of 50 is now underperforming the market and losing money.

However, what we can say about this approach is that:

  1. It's extremely simple.
  2. It appears to beat the heck out of the "below book / above twice book" approach.
And what's interesting is that, if we fiddle around with the EROI filter -- adjusting it between 3% and 12% -- the results still consistently beat the old rule. In some cases, it even gives us market-beating performance for the group of 50.

How to use this
I know there are some investors who would love some sort of automatic "set it and forget it" investing system that they don't have to think about. This isn't it. And the "buy below book and sell above twice book" definitely isn't it. Frankly, I don't think that overly simplistic system exists.

What this replacement rule of thumb is, though, is a good way to start your search for bank stocks worth investing in. Using this measure -- equity returns divided by price-to-tangible book value -- you can quickly identify banks worth further investigation. But it's at that point that you actually have to roll up your sleeves, dig in, and figure out whether that bank is really worth your investment dollars.