Why I Will NEVER Buy Another Bank Stock

My grandmother, a schoolteacher, was widowed at a relatively early age. She inherited a relatively small nest egg my grandfather, a rabbi, had built that included a couple of municipal bonds and 90 shares of stock in a small local bank started by a handful of his congregants.

At the time of her death 40 years later, the bank had grown into one of the largest regional players in the business. Those 90 shares had grown through mergers, splits and stock dividends to over 12,000 shares, with a value of close to $300,000. Not a fortune -- but not too shabby.

Was she some kind of investing genius? She was a smart cookie, but no. She held the stock for what seemed like forever. She banked there forever. She knew the business inside and out. She liked the 5% rain or shine dividend.

The bank she owned evolved into Regions Financial (NYSE: RF).

Investors had two glaring opportunities to take handsome profits before 93% of the stock's value was wiped during the financial crisis. The stock has recovered significantly since its panic lows -- but it is still far from its high and will probably remain so.

Now, when I say "banks," I'm not talking about the "too big to fail" (TBTF) banks -- like Citigroup (NYSE: C), Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM), Wells Fargo (NYSE: WFC) and the rest. While the TBTF banks all have substantial consumer banking franchises, the lion's share of their profits are earned from wholesale banking and capital markets, which are much more profitable than consumer banking.

I don't consider the TBTF firms to be bank stocks. They're more financial services stocks. They don't rely solely on a traditional bank model: selling checking and savings accounts, consumer and business lending, and residential mortgages.

Your formerly friendly neighborhood bank did all that and -- for a while -- made money at it. They would take in deposits, pay depositors one rate, lend the money out at a higher rate, and keep the spread. They made money consistently, even in tough economic times. Their stock performed well, and they paid their shareholders respectable dividends.

The business was almost utility-like -- but it won't be again for a long, long time. Here's why.

Following the "one-stop financial shop" model, banks wanted to be all things to all people. Retail-focused regional banks wanted desperately to get into the wealth management business.

For instance, Regions Financial acquired regional broker and investment banker Morgan Keegan in 2000 for $789 million. In 2012, still recovering from the financial crisis, Regions sold the unit for $930 million, which it used the money to help pay down its TARP (Troubled Asset Relief Program) debt.

Was it worth it for Regions to get into the wealth management business? An annual average return of 1.5% over a 12-year period is less than stellar. Regions would have made more money in Treasury bonds.

A Long Road Back

Thanks to the financial crisis of 2008, most regional and small banks have an extremely challenging climb ahead of them -- and thanks to the Federal Reserve's quantitative easing measures, they're flush with cash.

The idea behind QE was that the Fed would buy bonds from the banks, supplying them with cash that they would lend out to businesses and consumers, thus stimulating the economy. But amid fearful bankers, newly prudent consumers and restrictive regulatory policy, the money just stacks up and goes nowhere. And it will stay that way for quite a while.

So banks are being forced to return to their utilitarian roots. But will they be able to make money? I expect it will take a decade or so to regain public confidence and repair their relationships with alienated customers.

In the depths of the financial crisis and the ensuing Great Recession, regional and smaller banks effectively shut the window on small-business lending, refusing new credit and even calling existing loans. The crisis has passed, but many small-business customers are still getting the cold shoulder -- and these slighted folks will remember that when lending loosens up again.

Retail customers are also being alienated. After years of free checking accounts and lots of other value-added services thrown in, banks are now turning to fees to help pay the bills since there's no growth or money in lending. Customers are up in arms over the return of fees. Good luck with retraining millions of consumers who are used to getting something for nothing.

(If it seems like I'm picking on Regions, I am. It's a case study in the rise and fall of regional banks.)

Bank stocks (other than the TBTF firms) will do investors no good for maybe another decade. Their margins will be almost non-existent unless they learn how to make money the old fashioned way. Then they'll have to spend enormous amounts of money on customer acquisition which will further hamper profitability.

So what financial stocks should investors own going forward? Here are three ideas:

Risks to Consider: The biggest risk to any financial stock is the looming threat of rising interest rates. While rates pose a bigger risk for PennantPark, they're actually good for Aflac, as rising rates can increase investment income. AllianceBernstein's predictable, fee-based model also provides some defense.

Action to Take -- The combined basket of stocks has a blended dividend yield of 6.5% and a median forward P/E of 11.3, a 21% discount to the SP 500's 10 year average forward P/E of 14.1. Expansion of the P/E to around 15 would result in a possible total return of nearly 40% for the group -- much more than investors will make from bank stocks over the next decade.

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