What to Look for in Bank Stocks

Because banks became weapons of mass economic destruction in the 2008 global financial crisis, post-crisis regulations sought to defang financial institutions through increased capital requirements.

Those measures greatly reduced their risk, but also lowered their financial performance.

Despite this, two portfolio managers at the boutique international value investment manager Causeway Capital Management are salvaging undervalued assets amid the wreckage in the bruised banking sector.

In a Causeway newsletter interview titled “The Banking Evolution,” portfolio managers Conor Muldoon and Alessandro Valentini say they have increased the sector’s weighting to 15% of their international and 10% of their global portfolios by purchasing shares of banks that have successfully shed capital-intensive assets and low-return business lines.

The two value managers explain their portfolio selection criteria, with Muldoon noting that “some of our favorite bank holdings have already raised sufficient capital and shed assets to meet the capital requirements of Basel III,” though that regulatory standard does not take effect till 2019.

Market consolidation is another key criterion, with Valentini saying that “fully capitalized banks generally operate in markets where the competition has shrunk to a few key players. In the United Kingdom, for example, the vast majority of retail banking market share is held by only four banks.”

That consolidation also advanced in the U.S. during the Lehman Brothers crisis when JPMorgan acquired Bear Stearns and Washington Mutual, Wells Fargo acquired Wachovia—“all at distressed prices,” Muldoon says, noting that some of the largest U.S. banks are seeing returns on equity in the mid-teens, while much of the sector remains stuck in single digits.

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Encouraging their optimism is the current cyclical low of U.S. and European interest rates, which implies a forthcoming boost in “net interest margin” when rates eventually rise.

That profitability advantage is not evident in Japanese banks where net interest margin remains under pressure; despite this, Muldoon says some of Japan’s megabanks are attractive because they are trading at around book value and seeing loan growth.

In contrast, Australian and Canadian banks that have achieved both market concentration and financial strength are unattractive as investments because of their current high valuations. Nevertheless, Valentini says, they serve as models of institutions that have made the most of the current economic circumstances.

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Check out Sallie Krawcheck: Beware of Bank Stocks on ThinkAdvisor.