Bank Investing 101

Worldwide Invest Better Day 9/25/2012
Worldwide Invest Better Day 9/25/2012

Despite what the financial meltdown led many people to believe, "bank" is not an obscene four-letter word. Sure, you have to be careful when investing in banks, but then again, you have to be careful when making any investment.

With less than a week left before The Motley Fool's Worldwide Invest Better Day, my fellow Fools and I are continuing to offer content aimed at helping our readers become better investors. With that in mind, let's dig into some of the basics involved in investing in bank stocks.

Subgenres matter
The easiest way to split up banks is based on size. At the small end of the scale, community banks tend to be very simple operations -- they take deposits from customers and turn around and lend those deposits out to homebuyers and businesses for mortgage and commercial loans.

Step up to banks a little larger, and we're now talking about regional banks. These are now multibillion-dollar banks such as Regions Financial (NYS: RF) and M&T Bank (NYS: MTB) . While size differentiates these banks, so do the business lines. The smaller community banks are more likely to be wholly dependent on interest income -- that is, the difference between the interest they pay on deposits and the interest they collect on loans -- while regional banks are more likely to also have services like asset management that generate non-interest income. Regional banks are also more likely to lend via credit cards.

Finally, at the top end of the market, we have the megabanks. Perhaps also fairly termed the "too big to fail" banks, this group includes the likes of Bank of America (NYS: BAC) , Citigroup (NYS: C) , Wells Fargo (NYS: WFC) , and JPMorgan Chase. These gigantic institutions -- Wells Fargo is valued at nearly $190 billion -- are essentially one-stop shops for a wide variety of financial services. Like the smaller banks, they still take deposits and lend those deposits out, but they have a far greater footprint in non-lending businesses, including trading, investment banking, asset management, financial advisory, and insurance. For the most part, these banks also have international operations.

Do these differences matter? You bet they do. If understanding the operations of a small community bank is a college-level course, fully picking apart JPMorgan and its bevy of businesses is Ph.D.-level investing. To trot out the cliche "walk before you run," for the beginning investor, cutting your teeth by researching a small, straightforward bank is much better idea than immediately jumping into the quagmire that is a megabank.

What makes you so great?
To some extent, banking is a commodity business. The money that's being borrowed and lent out by one bank isn't any different from the money being borrowed and lent out by the next bank.

That said, it's still important to think about how a given bank differentiates itself. That differentiation -- or, as Warren Buffett likes to call it, "an economic moat" -- will be a major determinant in whether your investment is a multibagger standout or a flop.

The question then becomes how a bank can create a moat for itself in a highly competitive industry. For smaller community banks, stacking up to what the big boys offer can be tough. However, a small bank can be an expert in the locality that it serves. Relationships throughout the community could mean that borrowers will look to them before the bigger banks. As we look back on housing-meltdown Ground Zero, it's worth remembering that local expertise could also help a bank avoid making bad loans -- or, at least, allow it to batten down the hatches sooner.

For the biggest banks, their size is a considerable advantage. A bank as big as a Bank of America or Citigroup has the ability to leverage costs much more effectively than a smaller bank. This gives them the ability to offer things that smaller competitors can't -- convenient ATMs, a broader array of savings options, maybe even slightly lower loan rates -- all while maintaining equal or better profitability. The diversification -- both in business and geographic terms -- can also create advantages for the bigger banks. And we certainly don't want to forget the advantages that can come with a well-managed, well-known brand. While the former may be questionable right now, the latter is definitely true for the largest banks.

As for the regional banks that are sandwiched between the small fries and the behemoths, they can carve out their moat with some of the advantages from both ends of the spectrum. Comerica, for example, is small compared with JPMorgan, but large enough that individuals and businesspeople in their markets are likely to recognize the brand. At the same time, because the bank doesn't serve the entire country, it can potentially have a better finger on the pulse of the markets that it does serve.

The bottom line, though, is that when researching a bank as investment, it is imperative that you figure out what gives that bank an edge over its competitors.

The balance-sheet valuation
Most investors are very familiar with valuing a stock based on its profits. That may mean the widely known price-to-earnings ratio or, if you've been listening to me, perhaps the EBTIDA multiple.

Banking, however, is a balance-sheet-based business. Success in banking is earning solid returns on the assets on the balance sheet and, through those returns, growing the asset base over time. While it's possible to value a bank based on its profits, it's typically better to value it based on its shareholders' equity. While there's no hard-and-fast rule about what book-value multiple banks should trade at, they typically trade between 1 and 3 times book value. The multiple for any given bank will vary based on factors such as the rate of returns the bank earns on its equity and the faith that investors have in the balance sheet.

Ready ... go!
This should give you a basic understanding of where to start your research on a bank. But the best way to learn is to actually dive in and do some research. And the best place to start is with the company's annual report, which can be found on the bank's investor-relations website or the SEC website. Many banks also give periodic presentations to shareholders or at conferences -- these can also offer some great insight into that bank. Finally, sift through the bank's recent press releases and its past few earnings reports to get a sense for what's been happening recently.

To continue to learn more about banks -- and investing in general -- be sure to stay tuned into as we close in on Worldwide Invest Better Day. To learn more, click on the green bar.

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