Financials have trailed the general market by a large margin this year. The U.S. financial sector is down by 2.6% since the beginning of the year, while the S&P 500 is up 9.3%. Some legitimate concerns have been holding financial stocks back this year. It is likely that investors are anticipating that the cycle for investment banking income is at or near its peak. Additionally, problems in sub-prime lending have exposed how lending standards have deteriorated during the good times in recent years.
Of course, not all financial institutions are exposed to these factors to the same extent. As the whole sector has been dragged down in recent months, it could be a good time to look for banks that are not overly dependent on investment banking income and have reasonably conservative lending standards.
My approach here is to first look for financial institutions with attractive valuations and then find the ones that are least exposed to the aforementioned risk factors. For the valuation, I set up a scatter diagram with a five-year average return on equity on the x-axis and price / book value of equity on the y-axis. As we want to find banks with a high return on equity in relation to P/B, we focus our attention on the data points below and to the right of the trend line. Each dot on the graph represents a large bank (the smallest has a market cap. of around $15 billion). Most of them are North-American with a couple of European banks thrown in for good measure. 
The four banks that are furthest from the trend line are Capital One Financial Corp. (COF), Bank of America (BAC), PNC Financial Services Group Inc. (PNC), and Wachovia Corp. (WB). These may all be potentially good opportunities worthy of further inspection, but I will single out Bank of America as an attractive buying opportunity.
Bank of America has a diversified income stream and is rather conservative as banking institutions go. It has a great source of funding with by far the largest deposit base of U.S. banks and is neither overly dependent on investment banking income nor mortgage lending (although those are two of the bank’s primary growth opportunities). With a five-year average ROE of 18.9%, Price to Book of 1.6, and 10.3 times trailing earnings, it seems very attractively priced.
July 24, 2007 at 4:03 pm |
Very interesting! What do you think about COF? They are dropping even further.
July 24, 2007 at 6:58 pm |
I was intrigued by COF as well, but I am less familiar with it than BAC. I’m planning on looking at it more closely, but from what I can tell it looks cheap. I’m sure there are some financial institutions that are going to see a lot of loan losses in the next couple of years. Whether COF is one of them I don’t know.
August 4, 2007 at 1:24 pm |
the perception among banking professionals is that BoA is alot more agreesive tha anybody else among the banks. In the downturn they will suffer only slightly less than the Bear Stearns/ Maquaries of this world. Having said that, i like companies which run their business aggressively, its just not a good time to take a dip.
Another comment is that ROE may not be a good metric to judge a bank on. Banking is a financial business and inherently based on leverage, so generally speaking it is up to the management to set their own desired ROE by using more or less leverage. BoA having a high ROE simply may mean a higher degree of leverage. Perhaps a better measure would be ROA?
August 7, 2007 at 7:01 pm |
Thank you for your comment, Kotika. Bank of America has certainly been aggressive in terms of acquiring companies, but my point was that it is not as exposed to agressive lines of business such as subprime lending and investment banking as some other financial institutions. They may be considered aggressive in the world of conventional banking, I’m not familiar enough to say.
ROE is a very common metric when looking at banks, but as you point out it does not account for leverage. However, I wouldn’t say that ROA is any better as it doesn’t account for the riskiness of the assets. I checked out the financial leverage of Bank of America and at X11.4 it is lower than that of Citigroup (X17.5) and J.P. Morgan (X12), while a bit higher than that of Wells Fargo (X10.7).