U.S. stocks are slightly lower in early afternoon trading on Thursday, with the S&P 500 (SNPINDEX:^GSPC) and the Dow Jones Industrial Average (DJINDICES:^DJI) down 0.27% and 0.30%, respectively, at 12:51 p.m. EST. The muted volatility may be a result of equity traders steeling themselves for the Employment Situation report for February ("non-farm payrolls"); the consensus estimate calls for 191,000 new jobs, up from 151,000 in January.

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Image source: Mike Mozart. Republished under CC BY 2.0.

Banks: Buy or beware?
Let's turn from traders' concerns to patient investors' opportunity. Bill Gross, the "Bond King" who co-founded PIMCO, published his monthly Investment Outlook yesterday. In it, he opines on bank shares, which have suffered disproportionately in the downdraft that hit global markets this year:

The recent collapse in worldwide bank stock prices can be explained not so much by potential defaults in the energy/commodity complex, as by investor recognition that banks are now not only being more tightly regulated, but that future ROE's will be much akin to a utility stock... Banking/finance seems to be either a screaming sector ready to be bought or a permanently damaged victim of write-offs, tighter regulation and significantly lower future margins. I'll vote for the latter.

Three words can summarize a value investor's directing line of inquiry: At what price? In other words, how does the current price relate to a fundamental assessment of the company or sector in question?

Gross' comparison between banks' expected returns with those that prevail in the utilities sector begs question: If we assume that bank returns will mirror those of utilities, how do these sectors' valuations compare?

Focusing on the U.S. market, the following table compares valuation ratios for two sub-indexes of the S&P 500, the Utilities Index and the Banks Index:

 

S&P 500 Utilities Sector Index

(29 companies)

S&P 500 Banks Index

(17 companies)

Price/Earnings

16.7

10.4

Price/Book value

1.76

0.92

Dividend Yield

3.68%

2.34%

Data source: Bloomberg.

The utilities sector sports significantly higher valuation ratios and pays a much richer dividend yield.

Utilities' valuation premium over banks cannot be explained by a difference in expected earnings growth, since the latter are actually expected to grow their earnings faster:

 

S&P 500 Utilities Sector Index

(29 companies)

S&P 500 Banks Index

(17 companies)

Current-Year EPS Growth

2.2%

0.5%

2017 EPS Growth

3.6%

10.7%

2018 EPS Growth

6.7%

10%

EPS CAGR*, 2016-2018

6.4%

7.3%%

Long-Term EPS Growth

2.8%

8.5%

Data source: Author's calculations, Bloomberg. *CAGR: Compound annual growth rate.

And while it's true that utilities have an advantage over banks in terms of expected returns on equity (10.2% and 10.1% for 2016 and 2017, respectively, against 8.1% and 8.5% for banks), I don't think it's enough to explain the gap in valuations.

The answer to the puzzle: Risk, not return
Instead, I think that gap probably stems from the other component in the risk-reward equilibrium -- risk. Investors use a higher required rate of return to discount the banks' cash flows, compared to utilities', because banks are inherently riskier than utilities. Utilities do not precipitate global financial crises and their bankruptcy risk is much smaller.

It's my hypothesis that investors swiftly raised their required return on bank shares since the beginning of the year and this is the main factor behind the violent decline in share prices.

Was this justified? At the sector level, perhaps, but I continue to believe that the shift swept up a number of high-quality institutions in its wake that did not deserve that sort of penalty, including JPMorgan Chase and Bank of America.

Is banking, to borrow from Gross, "a screaming sector ready to be bought or a permanently damaged victim of write-offs, tighter regulation and significantly lower future margins"? Gross votes for the latter, but at the right price, it could be both. I don't think the sector as a whole is a "screaming" buy. However, it does look priced to outperform the broad market on a three- to five-year time horizon, and stock pickers can nonetheless find attractive opportunities in this area.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Bank of America. 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.