Some people prefer apples; others prefer oranges. Image credit: iStock/Thinkstock.
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The type of investor who buys shares of Wells Fargo or JPMorgan Chase is generally not the same type of investor who buys shares of Bank of America or Citigroup . This may be obvious to seasoned investors, but it's an important distinction for people who are new to bank stocks.
I've written on this topic before, but was inspired to touch on it again after reading a research note by RBC's Gerard Cassidy, one of the better-known bank analysts in the United States. Cassidy published the note on Monday, arguing that Bank of America and Citigroup may ultimately have to break into multiple companies in order to generate the type of returns that investors expect.
That's an interesting issue that I tend to agree with, but it was an ancillary paragraph from Cassidy's report that caught my attention:
We believe long-term investors who buy and hold stocks through a bank cycle are better off owning and holdingWells Fargo and JPMorgan. More active investors who can manage their portfolios more aggressively may consider owning/trading riskier bank stocks such asBank of America andCitigroup at certain parts of the cycle.
The thread Cassidy is pulling on concerns the distinction between a stock's valuation and the quality of the underlying operation. Wells Fargo and JPMorgan Chase are bets on the latter, as they're two of the best-run banks in the country.
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- Both are at the top of their respective market segments -- Wells Fargo in consumer banking and JPMorgan Chase in investment banking.
- Both are led by very competent executives -- Jamie Dimon at JPMorgan Chase and John Stumpf at Wells Fargo.
- Both not only survived the financial crisis, but thrived through it -- JPMorgan picked up Bear Stearns and Washington Mutual for pennies on the dollar, while Wells Fargo more than doubled in size thanks to its acquisition of Wachovia.
The upside in these stocks, in turn, doesn't derive from a short-term valuation play. Because of the quality of these companies, shares of JPMorgan Chase trade at right around book value, while Wells Fargo's shares trade for a 50% premium to its book value. The upside for these companies is thus tied to the long-term impact of superior profitability on their shareholder returns.
Bank of America and Citigroup, meanwhile, have been much less competently managed during the past decade.
- Both would have failed during the financial crisis, but for the assistance of the federal government.
- Both continue to generate subpar profitability.
- Both remain under the watchful eye of regulators, who have staunched Bank of America and Citigroup's attempts over the last few years to more aggressively return capital to shareholders.
The net result is that Bank of America's and Citigroup's shares trade for meaningful discounts (roughly 40%) to book value. A bet on one of these two banks is thus a bet on the likelihood that their valuations will revert to the mean -- that is, to around one times book value -- as they continue to distance themselves from the 2008-2009 crisis.
Consequently, if you're looking for bank stocks that seem to offer more short-term upside, and you're comfortable with risk, then Bank of America and Citigroup are compelling options. But if you would rather buy and hold a bank stock for many years, then the better options among the nation's biggest banks are Wells Fargo and JPMorgan Chase, which are positioned to compound their earnings at a higher rate over the long term.
The article Why Long-Term Investors Should Prefer Wells Fargo and JPMorgan Chase Over Bank of America and Citigroup originally appeared on Fool.com.
John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short May 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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