The Best Deals in Bank Stocks

Editor's note: This story has been updated since it was published September 8.

Just a week after investors breathed a sigh of relief that the government was taking over Fannie Mae and Freddie Mac, they were greeted September 15 by more fallout in the financial sector. This time the news was that 158-year-old brokerage firm Lehman Brothers had filed for bankruptcy, Bank of America had agreed to buy Merrill Lynch and American International Group was struggling to stay afloat.

In the big picture, though, there are good 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.

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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 confirm 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 Bankstocks.com Web site. Brown, a former Wall Street analyst, also notes that in the credit crisis and recession of 1990-91, banking stocks bottomed in October 1990, as banks' loan losses were still increasing.

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 look for opportunities among three broad swaths of the banking sector: money-center banks, national institutions that often combine the roles of both traditional banking and investment banking; small, regional banks; and investment banks, which help businesses and government entities raise funds.

Rather than try to profit by investing in the most beaten-up and humiliated names, home in on those companies strong enough to wrest market share from their bludgeoned competitors. 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 big "universal," or 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 both buyouts across the globe and the ATM down the street.

Straddling the divide between investment bank and brick-and-mortar bank, JPMorgan Chase & Co. (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, or $10 a share. Standard & Poor's analyst Stuart Plesser says he can already 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, which have done "skimpy reserving," he says. The stock, at $37.00, is down 15% for the year. It trades at 11 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) has the biggest base in the country, accounting for nearly 10% of all bank deposits. Thanks to a series of regional-bank purchases, BofA is like a supersize regional bank itself. 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 conservatively that Bank of America is worth at least 15% of its deposits. After its 21.3% drop September 15 on news that Bank of America was buying Merrill Lynch for $50 billion, the stock, at $26.55, trades for 15.4% of the value of BofA's deposits. The price-earnings ratio, based on forecasted 2009 profits of $3.29 per share, is 8.

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.

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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 $31.00, it trades at 13 times estimated '09 profits of $2.31 a share.

Captive to housing

Moving to smaller fare doesn't do much to downsize 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. The New Jersey bank operates primarily in New York, Connecticut and its home state, and it owns all the mortgages it originates rather than selling them to investors. Hudson City 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 stock is up 24% year-to-date, so this is no fire-sale stock. At $18.80, 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 hasn't 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 $17.34, the stock is down 35% this year. It sells for 12 times estimated '09 earnings of $1.50 per share.

Down but not out

The big investment banks are the shakiest group. Lehman Brothers filed for bankruptcy September 14 and Merrill Lynch agreed that same day to be sold to Bank of American. As investors have grown wary of this bunch, the cost of borrowing money has increased, eating into their bottom lines, and some analysts think that regulators will permanently rein in how much money investment banks may borrow. Plus, prospects for many of their core businesses -- such as advising on mergers and acquisitions, financing buyouts, and underwriting debt -- are bleak, at least over the short term.

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 is the sole member of the big four to have churned out a quarterly profit 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.

Despite the pair's steadier footing, their shares took a hit September 15 along with the rest of the financial sector. Shares of Goldman Sachs, at $135.50, fell 12% September 15; Morgan Stanley, at $32.19, lost 13.5% on the day. Goldman trades at 7.4 times estimated 2009 earnings of $18.11 per share, while Morgan Stanley sells at 6 times estimated profits of $5.46 per share (both companies' fiscal years end in November).

Four financial funds

Banks' financial statements are dense stuff, so you might want to let an expert do the grunt work by investing through a fund. Veteran bank expert David Ellison, who manages FBR Large Cap Financial (FBRFX), began turning bullish on the sector in July. He's looking for cheap stocks of companies that won't have to raise any more cash. The fund is down 19% over the past year through September 5 -- that beats 78% of financial-sector funds. It returned 7% annualized since its 1997 inception.

Jeff Arricale, who manages T. Rowe Price Financial Services (PRISX), says he's finding plenty of opportunities within the sector. Among banks, he likes regionals with valuable deposit franchises that trade close to their liquidating value. He hedges some of his stock exposure to big companies by buying their convertible bonds. The fund gained 8% annualized over the past ten years, but it's down 23% over the past year.

To forgo stock picking entirely, consider a financial-sector exchange-traded fund. KBW Bank ETF (KBE) offers exposure to bank stocks only, while Financial Select Sector SPDR (XLF) provides a cross-section of the entire financial sector. Both funds have lost more than 25% over the past year but gained 36% and 11%, respectively, from the sector's most recent bottom, on July 15, through September 15.