You can hunt for the few promising investments in this risky sector, but in general you should stay away from financial companies. By James K. Glassman, Contributing Columnist May 6, 2011 Should you get back into bank stocks? Although the broad U.S. market, as represented by Standard & Poor's 500-stock index, is down only 15% from its 2007 high, most financial stocks are still suffering. Financial Select Sector SPDR (symbol XLF), an exchange-traded fund linked to an S&P index that holds the biggest banks, is off more than half from its 2007 high. So is iShares Dow Jones U.S. Regional Banks Index (IAT), another ETF. Shares of Bank of America (BAC), the largest U.S. bank by assets ($2.3 trillion at the end of 2010), are still down 74% from their peak. And Citigroup (C), the third-largest, still trades at 90% below its high (prices and other data are through April 8). Reasons for Concern Bank stocks continue to be depressed because legitimate financial fears still linger. With economists on average estimating growth in U.S. gross domestic product at 3.3% this year, the recovery remains anemic in comparison with past upturns. Despite predictions that the real estate market will soon turn up, housing sales continue to languish. The Dodd-Frank financial reform bill "has spawned a number of new regulations that are already taking a big bite out of banks' noninterest revenues," writes Theresa Brophy in the Value Line Investment Survey. And there are continuing doubts about whether banks have enough capital to weather another downturn. Advertisement Still, balance sheets of many banks are getting sounder, and financial regulators think it's time to spring some financial institutions from the penalty box. The feds have started to allow banks that pass stress tests to reinstate or boost payouts and to use excess cash to buy back their own shares (for another take, see Interview With Anat Admati: Banks Still Too Sick to Pay Dividends). Those favored include JPMorgan Chase (JPM), Wells Fargo (WFC) and Goldman Sachs Group (GS). (Stocks in boldface are those I recommend.) Ignominiously rejected was Bank of America, which is currently paying stockholders a penny a share each quarter. With the stock at $13, that amounts to a piddling yield of 0.3%. Meanwhile, Citigroup says it will begin making quarterly payouts of a penny per share following a one-for-ten reverse stock split. After the split, Citi will trade for about $44 and yield less than 0.1%. In fact, few of the big bank stocks have attractive dividend yields. JPMorgan is the standout at 2.1%. Morgan, which in 2008 gobbled up failing Washington Mutual, is the darling of the moment. The second-largest U.S. bank by assets -- and by far the largest by market capitalization -- its stock has suffered the least among big banks, off just 12% from its 2007 high. S&P analysts recently reaffirmed their buy rating for Morgan, estimating that it will earn $4.69 per share in 2011. At $47, the stock trades for ten times that estimate. For Morgan and nearly all the others, the big question mark is the expense item known as the loan-loss provision -- an estimate of loans that will go bad in the future. Morgan's provision peaked in 2009 at an incredible $32 billion -- or twice as much as the company's profits in its very best year. Value Line estimates that the provision will drop to $13 billion in 2011. The number is important because changes in either direction can greatly affect earnings. Advertisement That's the trouble with banks. For investors, a bank is a black box. Because you can't examine its loans -- in most cases, a bank's most critical assets -- you really have no idea how sound it is or how its profits will be affected by loans that go sour. Diversification offers some protection, but if another financial crisis comes along, the stocks of just about every bank will be affected. Even Morgan, the best of the big banks, fell more than 70% between its 2007 high and its 2009 low. PNC Financial Services Group (PNC), another bank with a strong reputation, dropped nearly 80%. How to Find the Best Banks? One promising approach is to look for the ones that weathered the recent storm the best. For example, Cullen/Frost Bankers (CFR), based in San Antonio, saw its earnings drop only 14% between 2008 and 2009 and then recovered 44 cents of that 50-cent-per-share decline last year. The bank, which has $17.6 billion in assets, continued to increase its dividend during the crisis (as it has for the past 18 years). With the stock trading at $60, it yields 3.0%. Cullen/Frost benefits from doing most of its lending in Texas, where the economy has held up well. Similarly, earnings at Bank of Hawaii (BOH), with $13.1 billion in assets, declined from $3.99 per share in 2008 to $3 in 2009 but bounced back to $3.80 in 2010. It, too, raised its dividend between 2007 and 2010. With the stock at $47, the yield is now a sizable 3.8%. Bank of Hawaii is a favorite of analyst Brett Rabatin, of Sterne Agee in Birmingham, Ala., who lauds the bank for managing "expenses and credit very well." BOK Financial (BOKF), a Tulsa-based bank with $24 billion in assets, emerged from the financial calamity in even better shape than the other two. Earnings set a record in 2010, and analysts estimate that profits will edge up to $3.73 per share this year, compared with $3.34 in 2007. Dividends have risen every year since they were initiated in 2005. BOK also benefits from a relatively strong regional economy. At $52, the stock sells at 14 times estimated profits. Advertisement A second way to find good banks is to examine the ratings from an independent credit-analysis firm -- one that neither sells stocks nor charges fees to the banks it rates. One such firm, Weiss Ratings, of Jupiter, Fla., released credit grades in March for 7,604 banks. Only 12% received grades of B+ or better. Northern Trust (NTRS), with $84 billion in assets, was the largest bank with a B+ ranking. The bank, headquartered in Chicago, has a substantial and profitable money-management business and a reputation for not taking big risks. At $52, the stock yields 2.1%. Northern Trust's stock was hurt less than those of the megabanks during the financial crisis, and the company never cut its dividend. Bank of the Ozarks (OZRK), a longtime favorite of mine because of its conservative management, got an A- from Weiss. The bank has $3.3 billion in assets and operates about 80 offices in Arkansas, Texas and four southeastern states. It just hiked its dividend and, with the stock at $45, yields 1.6%. Unfortunately, we're not the only ones hunting for solid banks among the wreckage. Northern Trust's price-earnings ratio, based on estimated 2011 earnings, is a daunting 18. Bank of the Ozarks is not much cheaper. Its forward P/E is 15, compared with 11 for Wells Fargo and 10 for Bank of America and Citigroup. Advertisement The same problem afflicts the banks that weathered the storm: Cullen/Frost sells for 17 times estimated 2011 earnings and Bank of Hawaii for 16. So investors face a difficult choice. You can buy a questionable megabank trading for about ten times earnings or a sound, smaller bank selling at a P/E that's 50% higher. Frankly, I am not enamored of either alternative. Banks today are the kinds of stocks Warren Buffett has in mind when he says that stock picking is a game in which you stand with the bat on your shoulder until you get a pitch you really like. If you are absolutely compelled to swing, then commit to JPMorgan Chase, which, if S&P analysts are right, will generate record earnings this year. Or buy shares of Wells Fargo, which is seeing improving credit quality and is likely to raise its dividend; or BOK, the best of the sound and the small, even though it's more expensive than I would prefer. But instead of investing in bank stocks now, you might want to wait until the next big drop or until the economy starts to perk up. In this in-between period, both the bad and the good have little to offer. James K. Glassman is executive director of the George W. Bush Institute, in Dallas. His new book is titled Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence (Crown Business). He owns none of the stocks mentioned.