Bank Stocks: Reversing the "Size Discount"


Financials were the best-performing sector in the S&P 500 in 2012, rising over 25% and adding $430 billion in market value to the index. The top banks by market value did even better that, with Bank of America , Citigroup , and JPMorgan posting gains of 109%, 50%, and 32%, respectively. Nevertheless, all three continue to trade at a discount to their book value (an accounting concept that refers the amount by which a company's assets exceed it liabilities.) What are the levers their managements can pull to redress that situation?

Bank shares could double
CLSA banking sector analyst Mike Mayo thinks he has the answer. "When we ask, a large majority of investors indicate that breakups -- divestitures, downsizings and de-mergers -- would be good for stock prices," Mayo wrote in a note to clients yesterday (Wednesday). He thinks bank stocks could double if risk and cost of capital were brought down.

The credit crisis laid bare the risks inherent in assembling "financial supermarkets," a strategy for which empire-builders Sandy Weill and Ken Lewis, formerly of Citi and B of A, were the standard-bearers. At JPMorgan, last year's London Whale fiasco proved how fiendishly difficult it is to keep tabs on businesses of this scale and complexity, even for an organization with solid risk management culture. Instead of economies scale, these banks are now reaping a "size discount."

An unlikely trailblazer
If the high returns of the "go-go" credit boom years are no longer on offer, reducing risk and complexity is another route to share gains, by lowering the lower cost of capital. That isn't just theory: At the end of October, Swiss bank UBS announced it was reining in its investment banking ambitions, essentially shuttering its fixed income activity in the process. The shares ran up 6% on the news -- after having already gained 6.2% the previous day in anticipation of the announcement.

For B of A, Citi, and JPMorgan, there is another example closer to home. Wells Fargo , the nation's largest mortgage lender, trails its three universal banking cousins in terms of total assets. However, the market rewards its lending focus and conservatism by awarding the shares a 29% premium to their book value. As a result, Wells is now the most valuable U.S. bank, a title it discreetly acquired for the first time in May 2010.

Wells Fargo's dedication to solid, conservative banking helped it vastly outperform its peers during the financial meltdown. Today, Wells is the same great bank as ever, but with its stock trading at a premium to the rest of the industry, is there still room to buy, or is it time to cash in your gains? To help figure out whether Wells Fargo is a buy today, I invite you to download our premium research report from one of The Motley Fool's top banking analysts. Click here now for instant access to this in-depth take on Wells Fargo.

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Alex Dumortier, CFA, has no positions in the stocks mentioned above; you can follow him @longrunreturns. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Motley Fool newsletter services recommend Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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