For many decades, it was pretty easy to analyze bank stocks. You simply needed look at their balance sheets and where we stood in the economic cycle. In tougher economic times, banks stocks typically traded right down to tangible book value, as that was the price in which a bank could simply be liquidated or sold for its assets. In better economic times, banks were typically valued closer to 1.5 times book value, under the notion that a bank's assets could help generate impressive returns on investments.
Yet when long-standing restrictions against entering a wide range of banking services, from investment banking to retail branch operations, came down about 15 years ago as a result of the repeal of the Glass-Steagal Act, the industry really caught fire with investors. Faced with more robust growth prospects, many bank stocks started to drift up to two times book value, which became the new price point at which many banking deals occurred.
The recent financial crisis has changed all of that. A number of bank stocks have been so beaten down that they can trade below tangible book value. As this table shows, that's the case with some of the nation's largest banks. All of these mid and large cap banks continue to trade below book value.
There are two takeaways from these current low valuations. First, all of these bank stocks should benefit from an improving asset write-downs notwithstanding. The need for further write-downs now looks less necessary, as most of the bad loans have been purged from balance sheets. Taken together, these two factors could propel some of these bank stocks up 50% to 75% in the next few years., which will an expansion in their price-to-book (P/B) ratios, perhaps up to 1.25 or 1.5 times book value. Second, the book values themselves should continue to grow higher, as has been the case in recent quarters,
As I said back in December, the bank is repositioning itself as a key player in fast-growing emerging economies. Indeed, Citigroup now derives more than half its revenue from abroad. Although the bank's turnaround is not yet complete, the story should become a lot cleaner with each passing quarter, and eventually, investors should embrace the bank as a way to hedge against a falling dollar and as a way to have greater exposure to more dynamic economies elsewhere.
The small fry
In a similar vein, smaller banks that are trading well below book should hold great appeal. Either the price-to-book gap will close, boosting share prices, or they'll get acquired for their assets. The banking industry has been consolidating for two decades. That process was interrupted during the financial crisis, but it should in as the industry and the economy stabilize further.
Here's a look at some of the most severely undervalued bank stocks on a price-to-book basis.
(Same as above)
Guggenheim Securities has been tracking the industry's mergers and acquisitions activity and suggests banks situated in economically robust regions, or those that have strong brand resonance in local communities, are likely acquisition targets. Their analysts suggest Regions Financial (NYSE: RF), First Horizon (NYSE: FHN) and Synovus Financial (NYSE: SNV) represent potentially large deals, while Associated Banc-Corp (Nasdaq: ASBC), Bancorp Rhode Island (Nasdaq: BARI), and Pinnacle Financial Partners (Nasdaq: PNFP) are smaller fries that could be snapped up at a nice premium.
Action to Take --> All of the smaller banks in the table above are expected to report first quarter results in a matter of days. If operations appear to be healthy and book value remains well below share prices, then it may be time to pounce, as investors could eventually see outsized gains from these stocks.