5 Reasons You Shouldn’t Fear Buying Big, Bad Banks

Here’s why you should buy bank stocks: In the words of Warren Buffett, “Be fearful when others are greedy and greedy when others are fearful.”

Easier said than done, right?

Criticism against bank stocks is easy to come by. Financials are tied at the hip to the mortgage market — so as long as housing suffers, so will they. There are debt woes, too, since Moody’s recently warned it might downgrade Bank of America (NYSE: BAC), Citigroup (NYSE: C) and Wells Fargo (NYSE: WFC) as the government draws down its support for bank stocks. And, of course, there are fears that “mark to market” accounting tricks have so obfuscated these companies’ books that there could be billions in liabilities we don’t even know about yet.

If that doesn’t spark fear in the hearts of most investors, what would?

But that fear could be a huge buying opportunity. Yes, there is risk in the financial sector, but there is also the potential for long-term rewards. Remember in March 2009 when Citi stock tripled in three weeks? Or BofA stock, which jumped 400% in six months? Very risky calls for folks who bought in at the bottom — and very profitable ones, too.

So, if you are an aggressive investor, stop talking yourself out of banks for a minute and humor me as we cover five reasons bank stocks could be strong buys right now:

#1 Bargain Valuations

Bank stocks are cheap by almost every metric. Shares of major financials are at the lowest prices of 2011, with most picks 10% to 15% away from a new 52-week low and trading near levels seen in the summer of 2009. Also, price-to-earnings ratios and price-to-book ratios are crazy low. Take a forward P/E of around 6.6 for Bank of America, compared with the current year P/E ratio for the S&P 500 of around 16.

Most banks are trading at about 9.4 times earnings, according to FactSet Research. Yes, stocks that set 52-week lows sometimes keep setting them. And yes, valuation metrics like P/E and price/book are best compared within the sector to avoid an apples-to-oranges comparison. But that doesn’t mean you should just dismiss such rock-bottom valuations out of hand. Read: 8 Super-Cheap Information Technology Stocks.

#2 Loan Loss Reserves Recede

Lots of folks like to point out that revenue for banks has been going nowhere, and that most of the strides made on the earnings front has been from the release of so-called “loan loss reserves.” These rainy-day funds were set aside to deal with subprime mortgages and other bad debt — but now that less of that cash is needed to offset losses, it is being returned to the bottom line.

Critics call this an accounting fiction that means profits aren’t growing at all, but that doesn’t tell the whole story. While lending hasn’t picked up dramatically yet, the draw down of reserves is a very encouraging first step. If banks were standing pat, then you could assume things haven’t improved. That’s not the case.