Beat the Rush to the Banks

The stocks are still risky, but a comeback is around the corner.

As Warren Buffett once said, you never know who's been swimming au naturel until the tide goes out. And as investors have discovered, the U.S. banking system spent the better part of the past decade's housing bubble doing an underwater striptease. Now we're all getting an eyeful as banks, over-exposed to the sagging housing market, make a mad dash for cover.

Even with the U.S. government's takeover of ailing mortgage lenders Fannie Mae and Freddie Mac, banks will continue to turn up bare until the housing tide turns. From a locally originated mortgage held by a small bank to an esoteric debt security on the balance sheet of an investment bank, a loan is only as good as the collateral that backs it. And that collateral has been in a dizzying freefall.

But there are reasons to be optimistic about bank stocks. Chief among them: The decline in home prices is slowing. The Case-Shiller index of home prices in 20 major metropolitan areas is down 19% from its peak in July 2006, but its month-to-month decline peaked in February at 3% and has slowed each month since. In May, seven of the 20 markets saw an increase in prices, and in June, ten of 20 did. Moreover, the bailout of Fannie and Freddie should lead to lower mortgage rates, which should boost demand for homes.

That's not to say that home prices have bottomed, but they don't need to for bank stocks to stage a comeback. After all, the stock market is forward-looking, and stock prices tend to reflect economic trends before the data confirms them. "We're far enough into the problem that reasonable people can place parameters around the range of expected losses," says Tom Brown, a hedge-fund manager who operates the Web site.

Still, because banks run on borrowed money, a small margin of error can quickly expand to a gulf. Plus, bank executives have broad discretion as to how much detail they disclose about their holdings of mortgages and other assets. That's why banks are often called black boxes.Below, we suggest opportunities among three broad swaths of the banking sector: investment banks, which help businesses and government entities raise funds; money-center banks, national institutions that often combine the roles of both traditional banking and investment banking; and small, regional banks.

We've homed in on those banks strong enough to wrest market share from their bludgeoned rivals. That way, regardless of when stock prices recover, the piece of the business you own will be larger next year than it is today. As any former Bear Stearns shareholder could tell you, just because a stock is dirt-cheap today doesn't mean it won't be cheaper than dirt tomorrow.

Large and in charge

As a group, the money-center banks offer the biggest opportunities. Many boast immense deposit franchises, which offer a low-cost source of funding that won't dry up overnight. And because these guys are part investment bank and part commercial bank, they rely on diverse sources of revenue -- bringing in bucks from buyouts across the globe and the ATM down the street.

Straddling the divide between investment bank and brick-and-mortar bank, JPMorgan Chase & Co. (symbol JPM) is scooping up new business with ease. Its already formidable investment-banking division gained market share for a song with the company's acquisition of Bear Stearns in May for $2.2 billion. Standard & Poor's analyst Stuart Plesser says he can see evidence of JPMorgan's increasing share in residential and commercial mortgages and in consumer banking. "Particularly in the commercial area, companies want to work with a strong bank that they know they're not going to have to worry about," he says.

Management's openness about troubled assets earns it extra credibility. "I think they've been the most forthright in the industry about their problems," Plesser says. The company has been much more aggressive in shoring up its cash reserves and balance sheet than some other banks, he says. At $40, the stock is down a relatively modest 9% for the year. It trades at 12 times estimated 2009 earnings of $3.29 per share.

A strong deposit base can provide a floor for banks with a high exposure to risky loans. "There's nothing you can do with wacky accounting rules to change the fact that deposits are deposits," says Ladenburg Thalmann & Co. analyst Dick Bove. With deposits of $785 billion, Bank of America (BAC) accounts for nearly 10% of all U.S. bank deposits. Jeff Arricale, manager of T. Rowe Price Financial Services fund, says that customers are moving to Bank of America in a flight to quality, and "it has the pick of the litter in terms of making loans."

The company's outsized book of loans may still cause it some pain. Bank of America has a $120-billion home-equity portfolio and a $62-billion U.S. credit-card-loan portfolio. It finished its $3-billion acquisition of distressed mortgage lender Countrywide Financial in July, making BofA the nation's biggest mortgage lender. Although Countrywide lost $2.3 billion in the second quarter, BofA executives say they expect the mortgage lender to contribute positively to profits before the end of 2008.

At least the behemoth is already near its floor. Bove figures that Bank of America is conservatively worth at least 15% of its deposits. At a price of $32, the stock trades for 19% of the value of BofA's deposits. The price-earnings ratio, based on forecasted 2009 profits of $3.29 per share, is 10.

For the cleanest nose on the block, look no further than Wells Fargo (WFC). On July 16, the day after financial stocks in Standard & Poor's 500-stock index dropped 3%, the company reported a second-quarter profit of 53 cents per share -- handily beating the average analyst estimate of 50 cents. The company then thumbed its nose at naysayers by raising its quarterly dividend by 3 cents, to 34 cents per share.

Wells Fargo has largely sidestepped the worst of the housing crisis by keeping its lending standards high. Less than 10% of the loans it services are those of subprime customers, and the company has no exposure to interest-only or choose-what-you-pay loans. Wells Fargo is also the only U.S. bank with a top, triple-A credit rating. At $31, the stock, which is up 3% this year, trades at 14 times estimated '09 profits of $2.31 a share.

Captive to housing

Moving to smaller fare doesn't do much to trim risk. "The smaller the bank, the more closely it's tied to real estate," says Robert Eisthen, an analyst with Bartlett & Co., a Cincinnati investment firm. But you can still find small banks that never let frothy home prices go to their head, as well as those that have been unduly tarred by Wall Street.

In the former category, Hudson City Bancorp (HCBK) has been reaping the rewards of its firm lending standards. It operates mainly in New York, Connecticut and its home state of New Jersey. And rather than sell to investors the mortgages it originates, Hudson City holds them. It has no exposure to subprime mortgages or to loans with ultra-flexible payment options, and its customers have better-than-average equity in their homes.

The bank has reported record profits in each of the past five quarters and raised its dividend twice this year. The share price is up 22% year-to-date through early September, so this is no fire-sale stock. At $18, Hudson City sells for 16 times expected 2009 profits of $1.18 per share.

For shares with some bounce-back potential, consider Marshall & Ilsley (MI). The Milwaukee-based company has almost 200 branches in Wisconsin and a few dozen more in Indiana, Arizona and Florida, so it's exposed to ground zero of the housing crisis. Marshall took a big hit in the second quarter, posting a loss of $1.52 per share after making an $886-million provision for loan and lease losses.

But after taking that medicine, Marshall & Ilsley appears to be steadying. Arricale, the T. Rowe Price manager, says that even though the company has not had to raise capital or cut its dividend, the stock, which is selling at close to half its bare-bones accounting value, is trading as though it has. Says Arricale: "If management is right and the company doesn't need to raise capital or cut the dividend, then the stock will be a home run in a short amount of time." At $17, the stock is down more than 60% over the past year. It sells for 11 times estimated '09 earnings of $1.50 per share.

Down but not out

The investment banks are the shakiest group. Still, the winners are easy to spot. Both Goldman Sachs (GS) and Morgan Stanley (MS) have "the necessary capital and funding to weather the storm," says Phil Davidson, the manager of several value funds at American Century. Goldman has churned out profits in each quarter since the credit crisis began in the summer of 2007, while Morgan Stanley suffered just one quarterly loss, in the period that ended November 2007, because of loan write-downs.

Morgan Stanley may be best positioned to weather the worst. Brad Hintz, an analyst with Sanford Bernstein, an investment firm that caters to wealthy clients, says the company has the most diversified revenue base and the lowest exposure to risky loans of the major investment banks. "If you're going to tiptoe through a minefield," he says, "you don't want to weigh 300 pounds. You want to be the little guy."

Goldman Sachs benefits from its already glowing reputation -- everyone wants to work with the best. "It has the number-one investment-banking franchise in the world, and it has come through this thing without any bullet holes," Hintz says. Some hedge funds may already be switching to Goldman from its ailing competitors. Revenues in the securities-services group, which serves prime brokerage customers such as hedge funds, increased 36% in Goldman's second quarter (which ended in May) over the first quarter.

Investors are rewarding the pair's steadier footing. At an early-September price of $163, Goldman Sachs was down 24% year-to-date; Morgan Stanley, at $41, was off 22%. Meanwhile, Merrill Lynch and Lehman Brothers were down 50% and 75%, respectively. Goldman trades at nine times estimated 2009 earnings of $18.11 per share, while Morgan Stanley sells at eight times estimated profits of $5.46 per share (both companies' fiscal years end in November).

NEXT: Four Picks for a Packaged Approach

Most Popular

Dying Careers You May Want to Steer Clear Of

Dying Careers You May Want to Steer Clear Of

It’s tough to change, but your job could depend on it. Be flexible in your career goals – and talk with your kids about their own aspirations, because…
September 13, 2021
5 Top Dividend Aristocrats to Beef Up Your Portfolio
dividend stocks

5 Top Dividend Aristocrats to Beef Up Your Portfolio

The 65-member Dividend Aristocrats are among the market's best sources of reliable, predictable income. But these five stand out as truly elite.
September 14, 2021
7 Best Commodity Stocks to Play the Coming Boom

7 Best Commodity Stocks to Play the Coming Boom

These seven commodity stocks are poised to take advantage of a unique confluence of events. Just mind the volatility.
September 8, 2021


ETFs and Mutual Funds with Todd Rosenbluth
Index Funds

ETFs and Mutual Funds with Todd Rosenbluth

Which is better: ETFs or mutual funds? And how do you decide where to put your investments? CFRA fund expert Todd Rosenbluth has some answers. Also, h…
September 22, 2021
These 2 Emotional Biases Could Kill Your Retirement
Investor Psychology

These 2 Emotional Biases Could Kill Your Retirement

Are your emotions sabotaging your retirement plans? Some basic knowledge and careful introspection can go a long way toward avoiding major pitfalls.
September 20, 2021
Investment Strategies for the 4 Stages of the Economic Cycle

Investment Strategies for the 4 Stages of the Economic Cycle

The U.S. economy is cyclical in nature, surging ahead and pulling back in waves over time. Investors’ portfolios need to change with the rise and the …
September 19, 2021
Is a Target Date Fund Right for You?

Is a Target Date Fund Right for You?

You're busy, and poring over investments is a pain. Wouldn't a target date fund be easier? Take a look at their pros and cons to see if incorporating …
September 14, 2021