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Investing in bank stocks

May 05, 2011

By MoneyRates Team | Money Rates Columnist

The banking sector is one of the closely watched areas of the market. Investors have bought and sold bank stocks for more than 150 years. The stocks of publicly owned banks have always been one of the most important components of the stock market, typically leading rallies and sell-offs.

In the last recession, large banks like JP Morgan Chase, Bank of America and Wells Fargo Bank lost billions of dollars in shareholder equity as their shaky lending portfolios were exposed to a turbulent credit market. The faith of investors in what were once considered blue-chip stocks has now been undermined.

Now many banks have cleaned up their balance sheets and restored their capital reserves, and analysts are starting to raise ratings on bank stocks that were considered toxic a short time ago. A number of bank stocks are even considered undervalued. This means that the next wave in banking could be mergers and takeovers. Bank stocks that were out of vogue the last couple of years are now being closely watched for growth opportunities.

In addition to the potential for acquisition, many banks are showing promise because they did not partake in reckless lending or end up receiving bailout dollars from the government in the Troubled Asset Relief Program (TARP). The stocks of these banks could still be undervalued due to the contagion effect on all bank stocks from the biggest banking disasters. Investors can find regional banks, community banks, online banks and even some larger banks that are hidden gems. They just need to know where to look.

Bank stocks in 2011: What to expect

In 2010 bank stocks made a nice recovery after posting poor returns in 2008 and 2009. This year, the KBW Bank Index of large cap bank stocks shows that bank stocks are struggling. The index is down 2.89 percent for the year. The KBW index for regional bank stocks is also lagging the S&P 500 Index, but shows more promise. Bank analysts are forecasting that regional banks will increase profits in 2011, as well as return to share buyback programs and dividend increases to reward investors. Other predictions for banking in 2011 include:

  • Online banks, community banks and smaller regional banks will become targets for acquisitions and mergers from larger well-capitalized banks.
  • Banks profits will benefit from a steeper yield curve as banks take advantage of the margin between loan rates and deposit rates.
  • Regulatory pressure will begin to ease.
  • Tighter credit standards will lead to improved loan performance.
  • Bank dividend yields of between 1 percent and 3 percent will become more prevalent.

The Federal Reserve has provided the easy credit to help banks repair their balance sheets. Even after a sustained rally in the prices of bank stock, investors can still find undervalued bank stocks.. This is especially true with regional bank stocks that had a more cautious approach to lending, investing and expansion than the larger banks did.

Look for many regional banks to grow this year and attract more customers. One reason may be that regional banks can more easily keep their fees reasonable and pay better rates on deposits than the nation's largest banks. To find a bank stock to buy for your portfolio, use stock-screening app or software. Narrow your search by looking for stocks of well-capitalized regional banks that pays dividends, have a good tier 1 risk-based ratio, decreasing loan delinquencies and a price-to-earnings ratio below 12. The FDIC's website is a good place to compare the financials of banks.

Bank financials: Understanding the basics

A paradox about banks is that the banks with the best CD rates may be a great place to deposit money, but are not necessarily smart stock investments.The biggest risk to a bank are bad loans or what is more formally called a "credit risk." Mortgages, home equity loans, personal lines of credit, commercial loans and credit cards are all forms of loans that banks make with the expectation that they will earn income as principal payments are made on time.

Even with current mortgage rates still under 5 percent, many Americans continue to struggle to make their house payments. Anytime a consumer or corporation defaults on a loan, a loss occurs for the bank which must then be reflected on the bank's financial statement. This creates less profit or even a net loss for the bank. Bank stocks can also lose value when their assets depreciate with the market. Each bank has its unique level of credit and market risk that should be evaluated based on their outstanding loan and asset portfolio.

So how do banks actually earn money with all this inherent credit and asset risk? The primary goal of most banks is to manage the spread between deposits (liabilities, loans and assets) so that the income that they earn from loans and assets is greater than the interest it must pay on the deposits held for customers. This is called a positive net spread. The basic concept is that a bank needs to charge a higher rate of interest on loans than they pay out on their bank CDs and other deposit products.

Banks also derive income from fees they charge on their accounts, which could include overdraft fees, service fees, closing fees or processing fees. This income and the positive net interest rate spread, in general, has to be greater than the operating expenses, capital costs and bad loans that a bank writes off in order for a bank to be profitable. To make loans banks are sometimes borrowers themselves, borrowing from even larger sources of credit in order to lend out more money than they actually hold in cash reserves. Banks can face trouble if loan delinquencies accelerate and they struggle to make their own principal and interest payments.

Evaluating a bank's financial condition is important before deciding to invest in a bank's stock. Fortunately, banks are required to publicly disclose nearly all their financial information quarterly. This makes it easy for an investor to find online information for an individual bank regarding their loans, credit risk, interest rate spread, growth of deposits, and asset management. Is the bank growing too fast or too slow? Are delinquencies increasing? Is the bank creating a high overhead by opening too many branches? Are interest rates high enough to create profit opportunities for a bank? A careful evaluation of a bank's financial can help answer these questions. Comparing the financial statements of similar banks can also help investor find undervalued bank stocks. The FDIC and the Federal Reserve both list important data on the current financials of individual banks on their respective websites.

Big bank stocks vs. small bank stocks: Which are better?

An age-old question for investing in the stocks of banks is: Are large banks better than small banks? Every bank is different, but today bank investors are finding that many small regional banks have healthier balance sheets than the larger banks that became embroiled in the credit market debacle. The stocks of banks that were large enough to be included in the Standard and Poor's 500 Index have lost an average of more than 50 percent of their pre-2008 value, compared to the 24 percent loss seen in an index of regional banks for the same time period.

The day of assuming that large banks are better than small banks is probably over. As a general rule, any bank that grows their deposits or grows their number of branch offices too quickly can face growing pains. At the same time, a bank that doesn't grow its deposit base or loan portfolio is unlikely to increase profits consistently and pay competitive dividends to investors. The best answer for a bank investor is to evaluate each bank on their own merits and not give undue consideration to whether big banks are better than small banks or vice versa.

Bank stock dividends: Rewarding investors with cash

One of the positive features of investing in bank stocks has always been the generous rates at which banks sometimes pay dividends to their investors. In many cases, the dividend yield for a bank's stock is even higher than the rates on their certificates of deposit, money market accounts, savings accounts or checking accounts. Bank stocks can lose value, so comparing a dividend yield to a CD rate is not a fair comparison, but for investors who like a steady rate of income from their investments, bank stocks should be near top of their list.

Banks have traditionally paid consistent dividends because it builds up trust and confidence from the public. The banking crisis forced many dividends to be slashed by banks or be eliminated entirely. Now that profits are returning, bank investors are clamoring for higher payouts. Regulators like the Federal Reserve and the FDIC are on the other side of the table. They have publicly warned banks against stock buyback plans and dividend increases that are sometimes viewed as more about rewarding bank executives than individual investors. Despite the regulatory pressure, the improvement in bank profits and rising interest rates should combine to lift dividend yields on many bank stocks this year.

If you are searching for a good dividend yield on a bank stock, remember to proceed carefully, because the highest dividend yield is not always the best investing option. Don't forget that a high dividend yield can be more reflective of an abrupt fall in the stock's price than solid earnings or growth. This is true because the dividend yield of a bank stock increases when the stock prices decreases and vice versa.

Banks have been increasing their dividends in 2011. Many of the nation's largest banks were forced to receive approval from the Federal Reserve before they could enact a dividend hike. JP Morgan Chase, Wells Fargo and Citigroup all received this approval, while Bank of America failed a "stress test" and will have to wait until later in the year to raise dividends.

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