The Profitable Characteristics of Bank Stocks: Bank of America Corp (BAC), Citigroup Inc. (C)

3. When they pay for their errors, they pay big, but late.

When banks finally pay for their bad investments, they usually pay big. Because banks are highly leveraged, meaning they use a lot more borrowed money than shareholder capital, bad choices can translate into large losses per share. For example, the relatively minor “London Whale” total loss could shave about $1.84 off of JPMorgan’s pre-tax earnings per share.

Though the losses may be large, the good news is that they are also late. The bad investments are typically made quarters or even years before the loss is reported. Usually by the time investors hear about it, the bank has recognized their folly and stopped investing in that area.

Given these industry characteristics, there is an investing strategy that works pretty well with the banks:

First, find a reasonable fair value for the company. There are many methods of estimating a bank’s fair value. Capitalized “normalized” earnings or percentage-of-tangible book value are a couple of the most popular.

Second, wait for a blow up. Eventually a misstep will be reported and the share price will suffer. I’m currently watching for a possible downside to the recent mortgage refinance boom. The huge number of refi’s over the last few years has boosted fee income at many banks. Any slowdown in this business might result in a missed quarter and an inviting stock price decline.

Third, check out the cause of the ‘blow up.” It’s very important to determine if the bank’s mistake could be fatal. Because they operate on a small amount of shareholder capital, usually around 10% of assets, a serious problem could threaten the firm’s existence. Though it doesn’t happen often, banks have gone out of business when they’ve made a significant blunder.

Fourth, look to invest. If it’s determined that the blow up isn’t going to be fatal and if there is a decent margin-of-safety spread between fair value and market price, it’s usually worth considering for investment.

While there’s certainly more to investing in banks than what’s been summarized here, history has shown they have some great characteristics that make them an excellent area for consideration and study.

The article The Profitable Characteristics of Bank Stocks originally appeared on Fool.com and is written by Bob Chandler.

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