Six years after the financial crisis, many investors still shy away from the banking sector -- and who can blame them? Yet times have changed: Banks are much better capitalized, they've become more heavily regulated, and they have (hopefully) learned from their past mistakes. And the best part of all is that there are some good deals to be found. If you're thinking of tiptoeing back into bank stocks, here's a quick guide on how you can do it.
Low risk but still big reward potential
If you want to invest in banks but don't want to take on a lot of risk, the best way to do it is with one of the larger banks that focuses on consumer banking, as opposed to investment banking. Consumer banking is about as straightforward as a business can get. Banks borrow money at low rates and lend it at higher rates as mortgages, auto loans, and other personal and business loans. As far as large, stable, consumer banks go, three of my personal favorites are:
- U.S. Bancorp (NYSE:USB). This is one of Warren Buffett's favorite bank stocks, and for good reason. U.S. Bancorp runs an extremely efficient operation, with a return on equity of 14.1%, return on assets of 1.4%, and efficiency ratio of 54.3%.All three metrics are well above those of its peer group, which average 9.3%, 1%, and 62.4%, respectively. (Lower is better for efficiency ratio.) U.S. Bancorp is more "expensive" than its peers, but often you get what you pay for.
- Toronto-Dominion Bank (NYSE:TD). Known as TD Bank, this company is completely dedicated to mastering the art of consumer banking. At a time when many of the big banks are reducing their physical operations, TD is staying open late at night and on the weekends. The bank has grown its earnings at an impressive 11.4% rate over the past five years and has produced a 11.5% average total return for shareholders for the past decade, including the financial crisis. If its "America's Most Convenient Bank" concept continues to attract new customers, the best days could still be ahead for TD.
- Wells Fargo (NYSE:WFC). The biggest bank in the U.S. in terms of market capitalization, Wells Fargo has come a long way over the past couple of decades. My favorite thing about Wells Fargo is that is has mastered the art of cross-selling -- that is, getting existing customers to sign up for more and more products. As one example, 41.8% of Wells Fargo's customers now have a credit card with the bank, up from 38% a year ago.
The smartest guys on Wall Street
Investment banking is a completely different animal from consumer banking, with revenue coming from advisory fees for M&A and underwriting, managing client assets, and trading currencies, commodities, equities, and fixed-income instruments. As you may expect, investment banking revenue can be a little more unpredictable than that of consumer banks.
My favorite in the investment-banking space is Goldman Sachs (NYSE:GS), which just reported an excellent first quarter but has declined thanks to weak overall market performance as well as an analyst downgrade. Goldman beat the market's expectations in just about every part of its business, and trading revenue is finally rising for the first time in years. Goldman Sachs is well known for recruiting the best and brightest minds on Wall Street, and Warren Buffett himself has referred to an investment in Goldman as a "bet on brains."
For those with a little more risk tolerance
If you have a stomach for risk, you could consider one of the banks that are still dealing with the aftermath of the financial crisis. While there are a lot of smaller banks that fit this description, two big ones that immediately come to mind are Bank of America (NYSE:BAC) and Citigroup (NYSE:C).
Of the two, Citigroup is my personal preference right now. Over the past several years, the bank has done a great job of getting old assets off the balance sheet, and the legacy Citi Holdings division has gone from more than $400 billion in assets in 2010 to just $122 billion today. Now, this is still a significant amount, and Citigroup also has a substantial amount of exposure to emerging markets, but for just 79% of book value, the reward potential more than justifies the risk.
How not to invest money in banks
Just like any other sector in the market, there are some bank stocks to stay away from. I wouldn't touch any banks based outside North America right now. The economies in Europe as well as emerging markets around the world are not the most stable, and a lot of the banks that look like steals right now -- National Bank of Greece, for instance -- are just traps.
Also, for the time being I would avoid any banks with a lot of exposure to oil-related debt. Lots of small and midsized banks lent lots of money to oil companies, and given the recent collapse in oil prices, the risk of default has increased significantly.
For the most part, the banking industry is a much better place to invest than it was a decade ago, and there are some pretty enticing risk-reward plays to be found here.
Matthew Frankel owns shares of Bank of America and The Toronto-Dominion Bank (USA). The Motley Fool recommends Bank of America, Goldman Sachs, and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.