A Measured Approach to Buying Banks (JPM, BAC, WFC, C, STI, GS, MS)
The investment landscape constantly shifts. As money chases returns, prices adjust and fortunes are made and lost. For years, a massive bull market in which investors who bought dips and patiently awaited a market rebound saw their wealth increase reigned. As this pattern played out, a common source of investor interest was the large financial firms. Since the financials provide the credit that allows our economy to function, people who bought the financials on dips did very well. Then a credit crisis hit and the rule book was shredded.
As a value investor, I believe that any asset has value at the right price. Whether we are discussing a pile of broken furniture or stock certificates, buy at the right level and gains will come your way. This strategy serves as a trusty tool in determining when I should allocate capital.
The difficult part of using this strategy is determining when a value stock morphs into a value trap. Anyone who owned shares of Lehman Brothers or Circuit City now knows that stocks can go to zero. While these investors thought they were buying shares of large companies at cheap levels, the share price only became cheaper as bankruptcy beckoned. For most, the fine line between a value stock and a value trap is only visible in hindsight. Buying stocks entails risks, and you should only allocate capital if you are comfortable with the risks being taken.
Each week my free newsletter EPIC Insights scans for value and recommends areas where patient investors can allocate capital and earn strong returns. For this week’s fundamental trade, I recommend small positions in a sector that involves tremendous risk, but may offer even greater rewards – the banking industry.
I could cover thousands of pages discussing why an investment in the large banks is both risky and necessary. We know our economy will eventually recover, housing will eventually bottom, and markets will eventually function normally. When this occurs, banks will be at the center of the turnaround. However, we also know that banks do not fully understand the depths of their credit risk, more problems will eventually occur, and an intrusive federal government will make the environment more difficult.
Some banks are nearly 90% from their all-time highs and so low in price that they offer a perpetual option on the recovery of the U.S. financial system. Given the upside potential, I believe a stake in the large banks is warranted.
When dealing with such a risky trade, we must consider how to protect our capital. As Monday showed, banks stocks remain very volatile as fears of mounting losses and creeping nationalization increase uncertainty and lead to lower prices. For my part, I will use the same rules I apply when trading options-keep positions small, and only invest what you are willing to lose.
With that mandate in mind I recommend a 0.75% position in JPMorgan (JPM) Bank America (BAC), Wells Fargo (WFC), Citigroup (C), Sun Trust (STI), Goldman Sachs (GS), and Morgan Stanley (MS) as this week’s fundamental trade. With total exposure to the banking sector totaling 5.25% of the portfolio, we will do well when the sector recovers yet will not have a further weakening in share prices devastate our portfolio.
Sean Hannon, CFA, CFP is a professional fund manager and weekly contributor for StockTradingToGo.com. He runs EPIC Insights Weekly (subscribe) the free Sunday market newsletter, and is the founder of EPIC Advisors, LLC.
