3 Smart Ways to Invest in Bank Stocks

Updated

There's more than one way to skin a cat, the saying goes. Likewise, when you're thinking of investing in a bank, there's more than one way to size it up.

Here's a rundown on three of the things I look for when buying into a bank -- a blend of basics you would look for in any kind of company you're thinking of investing in, as well as metrics that apply specifically to banking.

1. Valuation
When talking about valuation as it relates to a bank, you're talking about price-to-book ratio, or P/B. P/B compares a stock's market value to its book value. P/B is calculated by taking the market capitalization and dividing it by total assets minus total liabilities.

(The good news is, you can usually find this ratio calculated for you already on your favorite financial data website, which for me is Yahoo! Finance. Go to Key Statistics, and you'll find it seven lines down from the top.)

Investors generally look at P/B to try and determine if a stock is undervalued, and therefore might be a value investment. P/B also gives you some idea of whether you're paying too much for what would be left if the bank went, well, bankrupt immediately. For banks, a good rule of thumb is to try to buy under 1 times book value and sell above 2 times book value.

As an example, Bank of America is trading right now with a P/B of 0.58. That's very low. This could indicate the stock is undervalued and is therefore a great buy, or it could mean there's something fundamentally wrong with the bank itself, keeping the valuation low.

I'm personally bearish on B of A; I still don't believe the superbank has exercised all its financial-crisis demons. So for me, a book value of 0.58 is a big red flag rather than a big green light. It's one number, but there are different ways of interpreting it, which is why it's never good to rely on just one indicator when thinking about investing in any company.

2. Who's in charge
This metric, if you want to even call it that, is far more squishy than P/B, but to me is possibly the most important of all. The person at the top can make or break an organization. CEOs set the pace for any company, and give it its focus, direction, and culture. I look for a firm hand, coupled with an open mind, a penchant for straight talk, and at least a dash of humility.

An example of a bank I'm invested in primarily because of its leadership is JPMorgan Chase . CEO Jamie Dimon gave such a strong performance in 2012, guiding the bank expertly and with humility through the terrible London Whale crisis, that when I bought shares, I essentially felt I was buying stock in Jamie Dimon himself. He also expertly guided JPMorgan in the time leading up to and throughout the financial crisis, bringing the massive bank through the crash about as clean as one could possibly be hoped for. For me, Dimon's leadership made JPMorgan chase a no-brainer bank investment.

3. Who the bank is lending to
Banks have many different ways in which to make money. But even in this age of derivatives and collateralized debt obligations, the very old-fashioned model of lending money and charging interest still counts. And in this age of a resurgent housing market, I've been looking at which banks are making hay in housing.

One of these banks is Wells Fargo . While it made fewer loans in the fourth quarter of last year versus the third quarter (\$125 billion versus \$139 billion, respectively), Wells is still the country's largest home lender. And with Ben Bernanke making a full-court press to bring the housing market back from the dead with his aggressive quantitative easing plan, being No. 1 in housing is a good place to be -- for both Wells and its investors.

Final Foolish thought
There are almost as many ways to invest as there are investors, but three basics listed above are easy to get one's head around and always good places to start when you're thinking about banks.

In case you didn't notice, Wells Fargo is one of my favorite banks in the market today. Its 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?