The banking sector is a good choice for value investing. Value investors look for stocks in which the market price does not fully reflect the business's future cash flows. Often, they aggressively buy when others sell during times of bad news, poor performance or weak economic conditions. When most chase after stocks as they gallop higher, value investors sell.
Value investors are focused on the long term. Distress in the broader market or on an individual stock basis is what creates opportunities for value investors to buy at appealing discounts. The banking sector is quite sensitive to the economic cycle, so it is susceptible to extremes in price and valuations that attract value investors.
At the Bottom of the Economic Cycle
At the bottom of the cycle, fear runs rampant. This is the climate in which emotions drive price rather than fundamentals. Stocks in the banking sector are hit particularly hard because they have massive amounts of leverage and are intimately connected to the economy. Bank balance sheets typically operate at leverage in the double digits, so a small loss in asset value can turn the banks insolvent. This augments irrational extremes that are typically found at market lows. (For related reading, see "Financial Markets: When Fear and Greed Take Over.")
When banks have made loans that need to be paid back, the risk of default is much higher. Further, new lending becomes difficult, as the economy makes everyone unwilling or unable to take on significant risk. Compounding these issues are the lowered interest rates, which make banking less profitable, although this is helpful for asset prices that help repair bank balance sheets.
Short Term Versus Long Term Investing
The perspective of a value investor can be better understood through Benjamin Graham's description of the stock market as a voting machine in the short term but a weighing machine in the long term. The meaning of this metaphor is in the short term, stock prices are determined by the emotions and opinions of market participants. However, in the long term, the price is driven by the actual performance of the business.
Graham is considered the father of value investing, emphasizing a focus on a stock's long-term fundamentals. Since bank stocks are perhaps the most susceptible to these emotional short-term forces given the leverage and nature of the business, it is natural that value investors are drawn to this sector.
Quantitatively, value investors seek out stocks with low price-earnings ratios. Sometimes, if a company is really struggling, it may be losing money, so this metric is less useful than sales or gross margins. Another measure of value is the price-to-book ratio. The book value of the company reflects the accounting value of the company after accounting for all types of liabilities.
(For related reading, see "What Economic Indicators Are Important to Consider When Investing in the Banking Sector?")