The Best Deals in Bank Stocks

At least the behemoth is already near its floor. Bove figures conservatively that Bank of America is worth at least 15% of its deposits. After its 7.8% surge on September 8, the stock, at $34.73, trades for 20% of the value of BofA's deposits. The price-earnings ratio, based on forecasted 2009 profits of $3.29 per share, is 11.

For the cleanest nose on the block, look no further than Wells Fargo ( WFC). On July 16, the day after financial stocks in Standard & Poor's 500-stock index dropped 3%, the company reported a second-quarter profit of 53 cents per share-handily beating the average analyst estimate of 50 cents. The company then thumbed its nose at naysayers by raising its quarterly dividend by 3 cents, to 34 cents per share.

Wells Fargo has largely sidestepped the worst of the housing crisis by keeping its lending standards high. Less than 10% of the loans it services are those of subprime customers, and the company has no exposure to interest-only or choose-what-you-pay loans. Wells Fargo is also the only U.S. bank with a top, triple-A credit rating. The stock climbed 7.6% on September and is up 11% for the year. At $33.56, it trades at 15 times estimated '09 profits of $2.31 a share.

Captive to housing

Moving to smaller fare doesn't do much to downsize risk. "The smaller the bank, the more closely it's tied to real estate," says Robert Eisthen, an analyst with Bartlett & Co., a Cincinnati investment firm. But you can still find small banks that never let frothy home prices go to their head, as well as those that have been unduly tarred by Wall Street.

In the former category, Hudson City Bancorp ( HCBK) has been reaping the rewards of its firm lending standards. The New Jersey bank operates primarily in New York, Connecticut and its home state, and it owns all the mortgages it originates rather than selling them to investors. Hudson City has no exposure to subprime mortgages or to loans with ultra-flexible payment options, and its customers have better-than-average equity in their homes.

The bank has reported record profits in each of the past five quarters and raised its dividend twice this year. The stock, which rose only 1.6% for the day, is up 24% year-to-date, so this is no fire-sale stock. At $18.67, Hudson City sells for 16 times expected 2009 profits of $1.18 per share.

For shares with some bounce-back potential, consider Marshall & Ilsley ( MI). The Milwaukee-based company has almost 200 branches in Wisconsin and a few dozen more in Indiana, Arizona and Florida, so it's exposed to ground zero of the housing crisis. Marshall took a big hit in the second quarter, posting a loss of $1.52 per share after making an $886-million provision for loan and lease losses.

But after taking that medicine, Marshall & Ilsley appears to be steadying. Arricale, the T. Rowe Price manager, says that even though the company hasn't had to raise capital or cut its dividend, the stock, which is selling at close to half its bare-bones accounting value, is trading as though it has. Says Arricale: "If management is right and the company doesn't need to raise capital or cut the dividend, then the stock will be a home run in a short amount of time." Marshall and Ilsley shares bounced up 6.6% for the day. At $18.21, the stock is down 58% over the past year. It sells for 12 times estimated '09 earnings of $1.50 per share.

Down but not out

The big investment banks are the shakiest group. So far, the remaining big four -- Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley -- have posted credit-related hits to net income totaling $70 billion. As investors have grown wary of this bunch, the cost of borrowing money has increased, eating into their bottom lines, and some analysts think that regulators will permanently rein in how much money investment banks may borrow. Plus, prospects for many of their core businesses -- such as advising on mergers and acquisitions, financing buyouts, and underwriting debt -- are bleak, at least over the short term.

Still, the winners are easy to spot. Both Goldman Sachs ( GS) and Morgan Stanley ( MS) have "the necessary capital and funding to weather the storm," says Phil Davidson, the manager of several value funds at American Century. Goldman is the sole member of the big four to have churned out a quarterly profit in each quarter since the credit crisis began in the summer of 2007, while Morgan Stanley suffered just one quarterly loss, in the period that ended November 2007, because of loan write-downs.

Morgan Stanley may be best positioned to weather the worst. Brad Hintz, an analyst with Sanford Bernstein, an investment firm that caters to wealthy clients, says the company has the most diversified revenue base and the lowest exposure to risky loans of the major investment banks. "If you're going to tiptoe through a minefield," he says, "you don't want to weigh 300 pounds. You want to be the little guy."

Goldman Sachs benefits from its already glowing reputation -- everyone wants to work with the best. "It has the number-one investment-banking franchise in the world, and it has come through this thing without any bullet holes," Hintz says. Some hedge funds may already be switching to Goldman from its ailing competitors. Revenues in the securities services group, which serves prime brokerage customers such as hedge funds, increased 36% in Goldman's second quarter (which ended in May) over the first quarter.

Investors are rewarding the pair's steadier footing. After rising 4.0% on September 8, shares of Goldman Sachs, at $169.73, are down 21% year-to-date; Morgan Stanley, at $43.27, advanced 4.6% on the day and is off 19% year-to-date. Meanwhile, Merrill Lynch and Lehman Brothers were down 49% and 78%, respectively. Goldman trades at 9 times estimated 2009 earnings of $18.11 per share, while Morgan Stanley sells at 8 times estimated profits of $5.46 per share (both companies' fiscal years end in November).

Four financial funds

Banks' financial statements are dense stuff, so you might want to let an expert do the grunt work by investing through a fund. Veteran bank expert David Ellison, who manages FBR Large Cap Financial ( FBRFX), began turning bullish on the sector in July. He's looking for cheap stocks of companies that won't have to raise any more cash. The fund is down 19% over the past year through September 5 -- that beats 78% of financial-sector funds. It returned 7% annualized since its 1997 inception.

Jeff Arricale, who manages T. Rowe Price Financial Services ( PRISX), says he's finding plenty of opportunities within the sector. Among banks, he likes regionals with valuable deposit franchises that trade close to their liquidating value. He hedges some of his stock exposure to big companies by buying their convertible bonds. The fund gained 8% annualized over the past ten years, but it's down 23% over the past year.

To forgo stock picking entirely, consider a financial-sector exchange-traded fund. KBW Bank ETF ( KBE) offers exposure to bank stocks only, while Financial Select Sector SPDR ( XLF) provides a cross-section of the entire financial sector. Both funds have lost more than 25% over the past year but gained 52% and 32%, respectively, from the sector's most recent bottom, on July 15, through September 8.