Big Upside Potential for These Banks

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

After a big banking crisis, the typical pattern to be expected could be something like this: first a dramatic fall in stock prices because of rapidly deteriorating fundamentals, this is usually followed by a stabilization period and in then we usually see a long term recovery in stock prices and fundamentals for the sector. Recent economic data is signaling that the worst may be over for banks, and they still offer some very attractive valuation levels for long term investors.

The Macro Fundamentals

The fiscal cliff, the never ending crisis in Europe, legal and regulatory risks and other factors could create heavy headwinds for the US economy in the middle term. If the economic scenario turns for the worse, banks will probably need to keep working on streamlining their balance sheets and growth opportunities will be limited until skies clear out.

On the other hand, real estate indicators have been surprisingly strong in 2012, and this could be fantastic news for the banks. There is still the problem of shadow housing inventory, which could become a heavy drag on the strength of the housing recovery. But the variables are moving in the right direction so far, and this could mean a big boost to banks and their profitability.

Like Morgan Housel recently wrote: “households have been buried in unaffordable debt for the last five years. But they've been shedding the burden, both by defaulting on debt, and paying it down -- a so-called "deleveraging." Their progress has been nothing short of remarkable: As a percentage of disposable income, household debt payments are now at the lowest level since 1993.”

The credit market is already showing some recovery signs, and there is plenty of upside room in terms of going back to the long term average levels as we can see from the data by the Federal Reserve Bank of St. Louis. If credit demand keeps growing over the following years, bank stocks could be facing a bullish scenario in the middle term.

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Corporate Fundamentals and Valuations

There are important differences regarding corporate fundamentals for big banks. Companies like US Bancorp (NYSE: USB) and Wells Fargo (NYSE: WFC) have been more conservative during the credit bubble, and they are recovering their profitability at a faster pace than their competitors. Citigroup (NYSE: C) and Bank of America (NYSE: BAC) have done much worse, and they are still well below their pre-crisis profitability levels. JPMorgan (NYSE: JPM) is somewhere in the middle of these five banks, not as good as US Bancorp and Wells Fargo, but not as bad as Citigroup and Bank of America.

The following chart compares Return on Equity ratios for the five banks as a measure of overall profitability, and it gives a good idea regarding the differences in financial performance among these institutions. It should be noted however, that the worse part seems to be already over for the group. Even Citigroup and Bank of America, which are doing worse than the rest, seem to be stabilizing lately.

<img src="/media/images/user_1532/roe_1_large.png" />

As shown by the Price to Book Value comparison, the difference in financial performance is well reflected in valuation ratios. US Bancorp and Wells Fargo are more clearly expensive than JPMorgan, which is also more expensive than Citigroup and Bank of America. Depending on how you you feel about the strength of the banking sector, you can choose among different possibilities with their own valuation attractiveness and risk profiles.

It should be noted however, that the five stocks look clearly cheap in comparison to their historical valuation ratios, so there is a lot to gain in the sector, especially if the macro environment continues improving in the middle term.

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Bottom Line

The banking industry will remain challenging for some time. But fundamentals are looking better, both from an economic and company-level point of view. The risk and reward proposition for the banking sector is attractive in the long term. Besides, investors can choose among different alternatives offering different levels of risk and potential for gains.

acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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