With Bank of America (BAC) trading at just a third of its book value, I frequently receive questions pertaining to its potential as a value investment.
Some value investors purport to be able to value banks. Some may actually be able to, while others may only think they are able to. For the average retail investor, however, it is just too difficult to determine the intrinsic values of these "black boxes", for several reasons.
First of all, determining the value of the assets of these institutions is a guess at best, without a deep understanding of the bank's loan portfolio. As we've discussed before, some businesses are easier to understand than others. With the complex behemoths banks have become, their business models are very difficult to understand. I can't honestly say that they fall within my circle of competence.
But even if one could determine what the assets are worth to some range of values, the amount of leverage used by the banks seriously clouds the value of the equity. For example, for Bank A, you may believe the assets are worth $10,000 plus or minus 10%; but if Bank A uses $9000 in debt to fund those assets, the remaining equity value could be anywhere from $0 to $2000. As long as the shares trade in that range, you have no idea if you're buying at a discount to intrinsic value. If one is wrong about Bank of America's liabilities, for example, even a seemingly large discount to book value can be completely wiped out.
Needless to say, the high debt levels used by banks also make them much more susceptible to collapse during downturns, which is a phenomenon we could see at any time without warning. Value investors much prefer companies with low debt, as these have much greater power to weather downturns.
Even if a bank is offering a high dividend yield of late (not BAC), it's extremely important to understand where that dividend is coming from in order to attain reasonable assurance that it is sustainable. Buying blindly for dividend yield is not an option. The dividend cuts that have taken place throughout this downturn have proven how susceptible this strategy is to an erosion of principal.
Are there circumstances under which I would buy banks? Certainly. Under a situation where the entire industry is undervalued for example, a purchase of a basket of several banks helps diversify away the risk of failures here and there. This is a similar situation to Francis Chou's approach on pharmaceuticals, where large amounts of research money are being spent, but it's unclear which companies will reap the rewards.
The bottom line is, buying individual banks is a risk unless you understand the value of what it is you're buying. Buying because stocks are down, or because momentum is up, or because yields are high does not adequately protect your capital.