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As a group, bank stocks are trading for a lower valuation than the broader market, but does this make them a buy? The answer to this question, at least in the opinions of Motley Fool analysts John Maxfield and Kristine Harjes, seems to be yes.

As John and Kristine discuss in the podcast below, investors appear to be over emphasizing the downward impact of low interest rates and higher legal and regulatory costs dating back to the financial crisis. While these are unquestionably weighing on the bank industry's current profits, once these issues are resolved, banks stand to generate billions more in revenue and earnings every year. 

A full transcript follows the podcast.

 

Kristine Harjes: Bank stocks are cheap. Does that make them a buy? This is Industry Focus.

Hello, and welcome to Industry Focus, financials edition. For The Motley Fool, I'm Kristine Harjes, and I'm here with our senior banking analyst, John Maxfield. John, how are you doing today?

John Maxfield: I'm doing great. Thank you very much for asking, Kristine.

Harjes: Awesome. So, today we want to talk about whether or not now is a good time to buy bank stocks. Then banking industry, on a valuation basis, looks pretty cheap. It's trading at roughly 17.6 times trailing 12 month's earnings. Whereas the broader S&P 500 is around 18.8. You look at that and you think, "We've got one of two things going on here. Either this lower valuation reflects some amount of lower profitability prospects going forward, or people are just crazy and these stocks are a bargain."

It's probably not one extreme or the other, but it's clear: there's still some concern about the industry, which took such a beating during the financial crisis -- some areas haven't even recovered. John, what do you think are some of the primary reasons that banks are trading at such low valuations?

Maxfield: I think it all boils down to a "hangover" from the financial crisis. If you look back -- as you know, and maybe the listeners know, I look at these more through a historical lens. If you look back over the last 100 years, we've seen a relatively large cycle with banks that started back with the great depression. For about two or three decades after the Great Depression banks didn't make as much money. We don't have very good data on their price valuations because they didn't make as much money, and it seems safe to assume their stocks were trading for lower valuations.

We're seeing that same thing since the financial crisis. There's probably two principle explanations for that. The first one, as a lot of people know: Banks have been subject to an enormous amount of legal liability since the financial crisis. I don't know what the most recent figure is, but I know that six months ago I calculated -- for Bank of America, which is the hardest hit on the legal side -- it had around $91.2 billion worth of legal judgments and settlements since the financial crisis. So, $91.2 billion. That sounds like a lot. It is a ton of money when you consider Bank of America isn't even earning $20 billion a year right now. Some of that was monetary, some of that was nonmonetary, but that's a lot.

So, you had that legal aspect. Then in the wake of the financial crisis, the Congress came through and passed Dodd-Frank regulations, and then there were some related regulations passed in Europe that we followed that had to do with how much capital banks are required to hold. So, when you add in all of those regulations you're adding in a ton of additional compliance costs at these different banks. When you raise costs, you're going to lower profitability.

So you have the legal stuff that's lowering profitability, and you have the compliance cost that's lowering profitability. Just one final thing that's hitting the banks: Because so many banks were hit so hard during the crisis their leaders seem to be more risk-averse right now than they were in 2005, 2006. So that's causing them to take fewer risks, and when you take fewer risks that means they make lower revenue.

Harjes: Touching on that legal liability; are those huge expenses done -- you've spent those on your lawyers and whatnot -- or is that potential what you could end up owing, and so it's really more of an uncertainty factor than a fixed expense?

Maxfield: The legal expenses are starting to taper off. There's no question about that. We're running up against the statute of limitations with a lot of that mortgage stuff and a lot of those big settlements have gone through. There's only so many big settlements -- the government can't be charging the banks with these same exact things over and over again. We've had a lot of the big ones go through, but because they increased regulatory oversight of the banks they're now picking up all these other things the banks are doing wrong.

Like, fixing energy markets, fixing interest rate markets, fixing foreign exchange markets; and these banks are incurring billion-dollar -- regularly, still incurring -- billion-dollar settlements with the government over these new things that are popping up. Now that the regulators are deeper in these banks, they're noticing them. I can't remember exactly how you phrased the question, but we are seeing legal costs go down.

It's not like these are added to their fixed expenses, but we just don't know how much longer these elevated legal expenses are going to last. Is it going to last another year? Is it going to last another two years? Another five years? That's the reason investors are looking at stocks thinking, "Wow, their expense base for the foreseeable future is high to earn a lot of money."

Harjes: So, uncertainty is definitely coming into play in that aspect. What about another thing that you haven't mentioned yet -- this is something we've talked about quite a few times on this show -- what about the role of interest rates? They're at a low and there's all sorts of expectations that they're eventually going to have to normalize. Does that come into play here? What's the story there?

Maxfield: I would say, aside from the expense angle, the biggest X-factor right now are low interest rates. If you look at how banks make money, they make money in two different ways. I'm talking now about the really big banks. They make about half their money from fee-based business. Let's say you have a checking account with them and they charge you $35 a year to have that checking account. Then say you have a few overdrafts on it and they charge $40 per overdraft. You have those fees that they can make money on, and then you also have things like asset management, they have investment banking; those are all fee based services. That's about 50% of their revenue.

Then roughly 50% of big banks' revenue comes from interest rate arbitrage. So, you take deposits and you pay a very low -- or a 0% interest rate -- on those deposits, or a really, really low interest rate on those deposits, then you take that same money and invest it in assets that yield 3%, or 4% more than the cost of those deposits. So you have that spread between what you're bringing in from your assets and what you're paying on your liabilities. That's about 50%. Well, when interest rates are really low, what banks have done over the past 40 years is, they've tied the lion's share of their loan books to short-term interest rates.

Let's say short-term interest rates are 1%. They'll say "We'll lend to commercial lenders" -- which is the lion's share of what the bank has on its balance sheet in terms of loans -- they'll loan to commercial lenders at 3% or 4% above 1%. So regardless of what long-term interest rates are doing, banks will always make money on their loan portfolios. However, when you take all this into consideration, when short-term interest rates are almost 0% right now -- 0.25%. They're ridiculously low because the Federal Reserve is still trying to make sure the economy is up and going.

That drives a bank's revenue down because if short term interest rates are 2%, banks are going to be earning 6% on those loans. But if interest rates are 0% they're going to be earning 4% on the loans. That 2% difference is an enormous difference when it comes to a bank's revenue. To wrap all this up, if and when interest rates do in fact normalize -- and I believe that they will, although I have no clue when that will happen, but I think if you look over history we go through these cycles.

When interest rates are low, then interest rates are high, then they normalize. I think we're headed in that direction. All the evidence points to that -- which I can see. When that happens -- when those short-term interest rates go up -- banks will earn a lot more in interest income, and that will really help them out.

Harjes: Do you think the low valuations across the industry as a whole are the result of people holding off on investing until you see those rates go back up and banks become more profitable?

Maxfield: I think so. I say that because institutional investors -- your big investors, your pension funds, your endowments, your hedge funds -- a lot of these guys are looking out -- particularly your hedge funds or your more frequent traders -- they're looking at a year, and 18 months out in terms of the revenue projections and their earnings projections. So if those projections are going to be significantly lower because short-term interest rates are so low, and because expenses are so elevated, then, yes: short-term interest rates most certainly are factoring in to current valuations.

That's where the opportunity for the individual investor comes in because individual investors don't have to give a quarterly report, an annual report to the investors and other people who have money invested in the funds. So you can take a longer time horizon to investing. Not only in bank stocks, but investing in stocks in general, and that will give you the opportunity to benefit from these longer-term trends.

Harjes: Of course, when we talk about 'is this a good time to buy bank stocks we are taking that longer holding period. For your individual investors: Do you think -- even understanding that we can't time the market -- do you think banks are a buy right now? Are there any particular values that stand out to you?

Maxfield: Let's just keep one thing in mind. That is that a modern economy has to have banks. You just have to have them. So we know there's going to be banks around, and we know that unless banks are overall nationalized -- I have a hard time believing that is going to happen anytime in the near future, or ever -- unless that happens, there's got to be a profit incentive to put capital into the banking industry. So you're going to have a bank industry, and it's going to be profitable, and at some point the profit's going to have to settle at a point where individual investors are comfortable getting into that.

We've seen over time, that's in that 12%, 13%, 14% return on equity which -- assuming a bank can earn that -- means they're exceeding the cost of capital, which is 10%. So there's a lot of opportunity for profit there, but the question is: which banks in particular are going to be the biggest beneficiary? The other thing we know about banks is that they are extremely prone to failure on an individual basis. So you can feel comfortable in the fact that banks will be around and that they'll be profitable, but you've got to be really careful in selecting the ones that you invest in. this is something we've talked about a lot on this program.

The best way, in my opinion -- and this is something I think about, read about and write about constantly -- in my opinion, the best way to determine whether or not a particular bank is going to be safe and make it through the next crisis -- which is inevitable -- is to look at how they did in the last crisis. If you look at that you're going to go with your Wells Fargos, your JPMorgans, your US Bancorps, your M&T Banks; banks like that.

Banks that not only have cracked the nut on cross-selling and generating a lot of revenue; but at the other end of that spectrum -- and this is another extreme -- they're also extremely good risk managers. That's the think you're going to want to look for in a bank stock.

Harjes: Are these really high-quality, well-performing stocks also trading at inexpensive valuations?

Maxfield: Yeah. If you look at any company, any type of bank, the better ones are going to be trading for higher valuations. Your US Bancorps, your Wells Fargos are going to be trading at -- give or take -- two times book value relative to your Citigroups, Bank of Americas; that are trading for discounts to book value. So, 25% below book value.

You're going to be paying a lot more for your good banks, but your good banks not only earn a lot more money and therefore are able to pass it on to you via dividends and share buybacks, and increases in book value; they're also in a much better position to not only survive the next inevitable crisis -- which could be five years down the road or 20 years down the road -- but even to thrive through that crisis. That's exactly what we've seen with JPMorgan and Wells Fargo.

Going into the crisis, Wells Fargo was just a regional bank that was basically operating through the west of the Mississippi. But because it was so well managed going into the crisis it was able to pick up Wachovia, which was actually larger than Wells Fargo, but it was extremely poorly managed. So Wells Fargo was able to pick them up at pennies on the dollar. It more than doubled in size in the midst of the worst economic downturn since the Great Depression.

Harjes: It definitely seems like you are a fan of Wells. Would you say that is -- looking at the trade-off between getting something at a good value, and getting a really good, quality bank; would that be your No. 1 pick?

Maxfield: I would say Wells or US Bancorp. Those two are actually related. If you look at the guys -- US Bancorp is a large regional bank. It's a fraction of the size of Wells Fargo, or JPMorgan, Citigroup, and Bank of America. But if you look at the founding story of US Bancorp, it was founded in a merger of two regional banks, and the guys who brought those two banks together -- they were two brothers -- were CEOs of two different banks; they got their formative banking experience from Wells Fargo.

So they basically apply Wells Fargo's model at US Bancorp. Then when you consider that Wells Fargo is not only Warren Buffett's biggest holding -- who's the greatest investor of all time -- he has also said that he and Charlie Munger -- who's the vice chairman of Berkshire Hathaway -- they gauge all other investments that they make based off Wells Fargo. It is the gold standard. So when you take those two things into consideration, I would say if investors are going to be buying bank stocks, they could do a whole lot worse than banks like Wells Fargo and US Bancorp.

As a result -- at least in my opinion -- those are probably the best bank stocks, irrespective of value, that you can buy today, or at any time.

Harjes: Well there you have it, folks. If you're looking for any more information on either of those two banks, or any of the banks that we cover at The Motley Fool; definitely check out Fool.com. There's some awesome articles by both John and all of our team of bank analysts. Before we sign off I wanted to let everyone know that we are offering a membership to The Motley Fool's flagship stock picking product called Stock Advisor. It's the lowest rate available for awesome Industry Focus listeners. If you're interested in learning more about the product -- which I can tell you is fantastic and has informed some of my own portfolio decisions -- check out focus.fool.com. Again, that's focus.fool.com.

Maxfield: Let me just add one thing. I know you're trying to wrap up, Kristine. I'm so sorry. If you're just talking about investing, there's a few things that we know; but our Stock Advisor service has consistently beaten the market for well over a decade. If you manage your own money for retirement, and if you, in any way, are interested in a really high-level, high-quality service that helps you decide which stocks to buy -- and this service has a proven track record -- the Stock Advisor is definitely something that you should look into.

Harjes: Absolutely. Thanks for adding that, John. Folks, thanks for listening. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for, or against. So, don't buy or sell stocks based solely on what you hear. 

John Maxfield has no position in any stocks mentioned. Kristine Harjes has no position in any stocks mentioned. The Motley Fool recommends Bank of America, Berkshire Hathaway, and Wells Fargo. The Motley Fool owns shares of 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.