Why Shorting Bank Stocks Is Deadly

Earlier in the week, I compared the valuation of BofI Holding to Bank of America. The central idea is that paying up for a higher-quality bank can pay off, but only if you're willing to hold for years and years.

Some have concluded that BofI Holding, having a valuation well above the banking average, is a very easy short candidate. That couldn't be further from the truth. In fact, shorting a high-flying financial stock can absolutely crush your portfolio. Here's why.

A high valuation is an asset, not a liability
A company's valuation is more important in the financial sector than in any other. The fact is most banks -- BofI Holding included -- have a pipeline of loans they can fill at any time. That means they have a place to put capital to work provided they have the money in the first place. (BofI Holding reported that its pipeline for jumbo loans reached a new record on its last earnings call.)

When a company has a high valuation, it can find money to put to work.

BofI Holding currently trades at over 4 times tangible book value. For every share available at $77, there is a loan book, cash, and other tangible assets worth roughly $19.25 backing it. When you look at it this way, BofI Holding looks really, really expensive. There's some rounding at play here, but the point is that BofI Holding is pricey when you look only at the current price to book value.

When valuation comes back to bite
Suppose that BofI Holding wanted to raise new capital. It calls up a few investment banks and starts working on a secondary offering to issue 25% more shares. The shares are sold, fees are paid, and BofI Holding collects about $250 million.

After the secondary offering, BofI Holding's tangible book value doubled. Its price to tangible book value falls to 2.7 times tangible book, down from 4 times tangible book value. In one quick move, BofI Holding's valuation plummets by one-third, without any movement in the stock price.

If you were hoping to short BofI Holding to capitalize on valuation compression, your whole thesis just went out the door. With so many small banks trading between 2 and 3 times tangible book value, it's hard to make the case that BofI Holding, at 2.7 times tangible book value, is overpriced. It does, after all, have a stellar loan portfolio, excellent returns on equity, and some of the lowest costs of any bank in the United States.

Thinking about the long run
I'm willing to admit this example is simplified. BofI Holding would need to find deposits to match its equity raises to leverage its balance sheet. And it would need to find new loans to write to put money to work.

But the point is, shorting banks solely on the back of valuation is extremely dangerous. A high valuation today can turn into a lower valuation tomorrow if a bank issues new shares.

The good news is, these mathematical realities go both ways. If you find fast-growing bank stocks you want to own, but don't like the price, add them to your watchlist. Wait for a secondary offering. Then reevaluate whether or not the price makes sense. Often, fast-growing, high-priced banks become much more attractive after they issue new shares to the public. 

A bank to buy and hold forever
Many investors are terrified about investing in big banking stocks after the crash, but the sector has one notable stand-out. In a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

The article Why Shorting Bank Stocks Is Deadly originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Bank of America and BofI Holding. The Motley Fool owns shares of Bank of America and BofI Holding. 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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