Bank stocks are an important part of a deep-value portfolio — especially right now. In the aftermath of the real estate and credit crisis many banks have seen their stock prices fall to levels not seen since the early 1990s. Small banks in particular are very cheap.
In fact, I consider small banks to be the trade of the decade — I’m looking for huge returns over the next 10 years and I have been buying them as fast as I can find them.
When I’m evaluating a small bank, my first question will always be “Is it cheap?” As with any other stock, I find this answer by looking at tangible book value. Everyone else on Wall Street looks at earnings and earnings growth — but I really don’t consider the income statement much when evaluating banks. I’m looking to determine tangible book and buy at a large discount to that value.
We then ask “Is it safe?” Safety is determined differently when it comes to banks. My first test is capital levels. Past the mandatory capital ratios that must be maintained, I prefer to look at the ratio of tangible equity to assets. This simple calculation divides total assets by tangible equity and expresses the result as a ratio. The higher the better here, as excess capital gives a bank room to buy back stock, pay dividends and survive difficult operating conditions … like the one we just experienced.
Next I look at nonperforming assets as a percentage of total assets. These are loans that have stopped paying for more than 90 days and are in danger of default or foreclosure. This number also includes collateral, usually real estate that has been seized in foreclosure and awaiting disposition. The lower this number, the healthier the bank’s asset and loan portfolio.
I break bank stocks up into three groups. The first is perfect bank stocks. These are small banks that trade below 90% of tangible book value, with an equity-to-assets ratio over 10. In addition, the nonperforming assets are less than 2% of total assets. These tend to be very small community banks with excellent management and rigid financial controls. When I find them, I simply buy them –they are the core of my “trade of the decade” bank stock portfolio.
I also consider special-situation banks. These are banks trading at 80% or less of tangible book value that either have nonperforming assets of more than 2% or equity-to-assets ratio less than 10. When I consider investing in these banks, I’m looking for improving trends in asset quality and capital levels. I also like to see a strong private equity or activist investor involved in these banks to increase the chances of improvement and higher stock prices.
The last is global giant distressed banks. When the enormous megabanks like Citigroup (C), Deutsche Bank (DB) and Bank of Ireland (IRE) fall on hard times, they’re usually worth buying for more speculative bank investors. The odds of one of these banks being allowed to fail are slim, and the long-term recovery can send the stock price higher by many multiples of the distressed price. I never take a large stake in these banks; even a small position can yield large profits while limiting my exposure to large losses. These may be cheap, but only the implied prospect of a bailout offers any measure of safety.
Banks may not seem like an exciting industry group, but I have made more money in boring little community banks than any other sector in the past 20 years. If you do some homework and pore over the financials, you can too.
At the time of publication, Melvin was long IRE.