Investing in bank stocks isn't for the faint of heart. Exhibit A: Multiple leading financial companies continue to trade for large discounts relative to their pre-financial-crisis highs. But this doesn't mean bank stocks can't be profitable. What follows are three stock market tips for investing in bank stocks in the safest and most profitable way possible.
1. Banks, by nature, are risky
The most important thing for bank stock investors to appreciate is that banks are incredibly risky. Because the typical bank is leveraged by a factor of 10-to-1, all it takes is a 10% decline in the value of its assets to completely wipe out its capital base and thereby render it insolvent.
On top of this, thanks to the concept of fractional reserve banking, in which a bank holds only a fraction of its deposits in actual cash and highly liquid investments that can be used to satisfy withdrawals, any concern about a bank's vitality can lead depositors to claim their shares of available cash en masse before it's too late to do so. That's what they call a "bank run."
It's largely for these two reasons that thousands of banks have failed in the United States during the intermittent (but not infrequent) panics that have swept the financial industry since the founding of the U.S. Throughout the 1920s and the Great Depression, for instance, 750 banks failed on average every year. During the numerous crises of the 1980s and early 1990s, an average of 220 banks failed on an annual basis. And since the onset of the latest crisis in 2008, more than 500 lenders have been forced to close up shop.
2. Cheap banks are cheap for a reason
Given banks' vulnerability to failure, it should come as no surprise that the most prudent approach for conservative investors is to seek the publicly traded lenders that are best guarded against this fate. One way to identify these is to examine how much their shares cost relative to book value.
Known as the price-to-book value ratio, this is the most common metric bank analysts use to compare the price of one bank's shares to another's. A ratio below 1.0 implies that a bank isn't earning its cost of capital and/or that the market is anticipating future losses. A figure above 1.0 suggests just the opposite.
Take Wells Fargo (NYSE:WFC) as an example. According to Yahoo! Finance, its shares trade for 1.71 times book value. This is a strong indication that the California-based bank is not only profitable now, but likely to remain so for the foreseeable future.
On the other end of the spectrum is Bank of America (NYSE:BAC); its shares trade for a paltry 0.76 times book value. This follows from the fact that the nation's second-largest bank by assets is still reeling from the financial crisis, in which it lost tens of billions of dollars thanks to toxic credit card loans, subprime mortgages, and countless legal judgments and settlements.
3. Find a bank with a high return on equity
The ultimate objective when investing in a bank stock is to find one that will generate a high return on equity for decades into the future, if not indefinitely. This figure is calculated by dividing a bank's annual net income by its shareholders' equity. The objective is to invest only in banks that return somewhere in the neighborhood of 15% on their equity on average through all stages of a business cycle.
To take this one step further, there are two things that a bank must do to maximize its return on equity through both good times and bad. First, it must keep its costs down. Well-run banks such as U.S. Bancorp and Wells Fargo devote less than 60% of their net revenue to non-interest expenses -- this percentage is known as the efficiency ratio. A poorly run bank like Bank of America spends much more -- sometimes well in excess of 80%.
The second thing a bank must do to achieve consistently high profitability is carefully manage credit risk. Every quarter, a lender sets aside a certain amount of money in anticipation for future loan losses. This is known as provisioning for loans losses, and for all intents and purposes, it's given similar accounting treatment as expenses. Thus the goal is to adhere strictly to prudent risk-management standards to reduce the likelihood that problematic loans make it past the underwriters.
Taken together, in turn, so long as a bank has a long history of efficient operations and prudent risk-management, then investors should feel comfortable assuming that it will generate a high return on equity going forward. And if it will generate a high return on equity, then the chances are good that it will also make a profitable investment.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America 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.