Let's face it, there's no easy way to pick stocks for your portfolio. Doing so requires a lot of hard work, research, not to mention money. And you'll need a viable strategy that fits with your short- and long-term goals. Maybe you're an index investor—a passive investor who chooses equities and hopes to mirror the returns of the overall stock market. Or you may be a growth investor. This type of investor looks for stocks gains based on a company's perceived value and its growth potential. Another strategy is value investing, which requires investors to weed through all the drama of trends in the market. Instead, value investors look for strong companies that try to maintain their momentum.

In this article, we take a look at value investing and whether the banking sector is a good play using this strategy. To make a long story short, the banking sector is a good choice for value investing. But just how do these two line up?

Key Takeaways

  • The banking sector is a good choice for value investors.
  • Value investors look for stocks that trade for less than their intrinsic value.
  • The banking sector pays dividends, which demonstrates a great history and provide investors with a share in profits.
  • Value investors are drawn to bank stocks, which are the most susceptible to emotional short-term forces given the leverage and nature of the business.

What Is Value Investing?

Value investing is a strategy used by people who choose stocks that seem to trade for less than their intrinsic or book value. Value investors look for stocks in which the market price does not fully reflect a business' future cash flows. Basically, these investors believe the stocks they choose are undervalued by the market. They often aggressively buy stocks at the same time that others sell—during times of bad news, poor performance, or weak economic conditions. But when most people chase after stocks that gallop higher, value investors do the opposite: They sell.

Value investors are focused on long term goals rather than the short-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.

The Banking Sector

The banking or financial sector comprises companies that provide consumers with financial services. This includes retail banks, insurance companies, and investments services firms. This sector has a great impact on the economy. The stronger it is, the stronger the economy becomes. But as the sector weakens—as evidenced by the events leading up to the Great Depression—the economy begins to trail. So a healthy, stable economy requires a strong financial and banking sector.

Many of the stocks in this sector pay dividends, which many value investors believe is a good sign of a company's quality. The longer the dividend history, the better it is for the investor, as it demonstrates a good track record of success. It also shows that the company has a history of providing investors with a share of the profits.

Dividends demonstrate a strong track record of success and provide a history of sharing profits with investors.

At the Bottom of the Economic Cycle

Fear runs rampant at the bottom of the cycle. This is the climate in which emotions drive price rather than fundamentals. Banking sector stocks 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 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 make loans that need to be paid back, the risk of default is much higher. And new lending becomes difficult, as the economy makes everyone unwilling or unable to take on significant risk. Compounding these issues are lowered interest rates, which make banking less profitable. This, though, is helpful for asset prices that help repair bank balance sheets.

Short-Term vs. 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 near term, stock prices are determined by the emotions and opinions of market participants. But 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.

Value investors seek stocks with low price-earnings (P/E) 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 (P/B) ratio. The book value of the company reflects the accounting value of the company after accounting for all types of liabilities.