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Profiting from Chaos- More on Bank Stocks

Posted by admin on November 22, 2007 in Investment Products

I wanted to follow up on my post last week on bank stocks. Clearly the end is not near any time soon- the latest numbers in the United States show housing starts surprisingly up but building permit applications down- which means things are ok in the near term but not great for the future.

But look at the valuations of the selected banks below (which I picked as a cross section of large financial institutions in the United States and Canada). I am going to concentrate on two financial ratios: price to earnings (how much are you willing to pay for $1 of earnings) and price to book (which compares the price of the stock against the book value of a company’s assets and arguably a more accurate measure of bank stocks; remember book value is cost of acquisition and not the current value of the asset; for inflation protected assets like real estate book value is traditionally lower than its true value today).

As a basis of comparison, value investors consider a price to book (p/b) of under 1.5 to be a value stock (in other words, for every $1.00 of book value, the stock trades at only a 50 cent premium) and in the last 50 years the average price to earnings (p/e) for the S & P 500 is 12 (in other words, someone will pay $12 for every $1 dollar of earnings). Thus, I will assume a p/e under 12 is a bargain stock or a dying stock. If I am losing you, just keep in mind1.5 and 12; anything below 1.5 and 12 is considered to either be a dying company or a value/bargain stock.

I took the ratios as of closing on November 20:

Bank of America: p/b 1.41 and p/e 9.70

Wells Fargo: p/b 2.12 and p/e 11.51

Citigroup: p/b 1.25 and p/e 8.45

Royal Bank: p/b 2.83 and p/e 11.95

TD Canada Trust: p/b 2.31 and p/e 13.10

ScotiaBank: p/b 2.67 and p/e 12.43

(I own both Royal Bank and TD).

Some observations:

1. Scotiabank and TD Canada Trust appears not to be a value stock given it has a high p/b and p/e. I believe, as a shareholder, TD stock is over-priced (not that I am complaining); it seems to be the darling of the Canadian banking sector because it has done so much lately (financed the BCE deal, bought a bank in the United States etc). Scotiabank has the least amount of exposure to North American financial woes; its high p/b may be due to the fact it has a much higher proportion of assets in cash than its counterparts (at least as of last quarter’s financials)
2. Citigroup and Bank of America are the 1st and 2nd largest bank in the United States and they both have value stock range p/b and p/e. This means either the market is overly punishing their stock for the subprime and asset-backed commercial paper issues or they are dying companies. I’ll let you draw your own observation but if the 1st and 2nd largest bank in the United States are in financial trouble then we got a lot more to worry about then some mortgages being lent out to the financially unworthy.
3. The ratios tend to support the argument that Canadian banks are over-valued relative to their global counterparts. Royal Bank always has high valuations because of its branding and the fact it is designed to be a retail friendly stock for Canadian investors (the CEO has publicly stated in the past that they try to cater to the retail investor). With BCE being de-listed, we may see more money be invested in Royal Bank as a tried and true widows and orphans stock.
4. Funny observation- what does Buffet know that we don’t if he’s consolidating positions in Wells Fargo when its p/b is higher than its larger counterparts? Citigroup was already under some pressure from the market for being too big and not nimble enough but it is interesting that Buffet buys a bank that has higher than desired p/b.
5. I have said this several times- I am not sure when the end will come (no one is) but if the investing horizon is quite long (5 years plus) and you don’t believe that banks are dying companies, this sector may be something to explore. If the horizon is short then please look elsewhere. In the short term, the Canadian banks begin reporting Q4 results in 7-10 days; the comments that accompany the financials will be interesting to read. As usual, please do your own due diligence. Thanks.