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Banks. It’s time to buy

Global financial markets have taken another stomach-churning downward spiral. Banks are in the firing line, with Bank of America and Citigroup plunging more than 10 percent in U.S. trade.

Was it only yesterday Commonwealth Bank of Australia (ASX: CBA) reported a record first half net cash profit of $6.84 billion? And the day before that National Australia Bank’s (ASX: NAB) quarterly update showed it to be on track to beat full-year analyst estimates?

All is quickly forgotten when markets panic, and selling is indiscriminate. But as legendary U.S. investor Shelby Davis said, “You make your money during bear markets; you just don’t know it at the time.”

Challenging my bearish beliefs

The world’s greatest thinkers often talk about challenging cherished beliefs. Without challenges to our beliefs we’d still be living on flat earth at the centre of the universe.

“Any year that passes in which you don’t destroy one of your best loved ideas is a wasted year.”

That’s great advice from Warren Buffett’s long term friend and colleague, Charlie Munger, the champion of independent and rational thought and an inspiration to value investors around the world.

This week I challenged my bearish beliefs on banks.

I turned bearish on banks in November last year, and sold out by February. It was a tough decision.

Up till then, Australia & New Zealand Banking Group (ASX: ANZ) and Westpac Banking Corporation (ASX: WBC) had propelled my Australian portfolio to new highs, with financials rising from 0% to 27% of my portfolio in two years.

But despite the major banks appearing to be over the worst of the GFC, and with their profitability improving, I was becoming increasingly uncomfortable.

My bearish view was driven by valuations, the looming risks of an over-valued property market, and global recession. Whether due to one of those catalysts or a black swan event – something financial institutions are especially prone to – I decided banks would present a better buying opportunity down the track.

I hadn’t expected that we’d get down that track so quickly. With most of the banks now down more than 20% from their recent highs, it was time to recheck my thinking.

Valuation

Equity risk is now priced into banking shares, as is a low quality of growth. The major four banks all offer a good margin of safety and are well capitalised. Their attractive yields alone are one huge reason to start buying banks.

Commonwealth Bank offers the lowest yield at 6.4%, but is the safest bank. NAB is yielding 7.8%, with my old favourites ANZ and WBC offering up juicy dividends of 7.3% and 7.9% respectively.

Beliefs

Sentiment on the banks has soured. Markets are panicking. Cracks have appeared in real estate, and the property bulls are no longer sure demand is enough to keep our real estate values inflated.

The screams of global meltdown are intensifying. Banks selling is intensifying. Before yesterday’s rally, the big four had fallen between 8% and 14% in just the last 5 trading days.

It was time to put my bearish beliefs under the blowtorch.

I thought China would stumble, sooner rather than later. But what if the growth story continues? The Nobel Prize-winning economist, Michael Spence, who advised China on its latest five-year plan, thinks the China growth story can continue for two more decades.

Could that mean another twenty years without recession in Australia? I know forty year olds who haven’t experienced a recession. Could they reach retirement without suffering a recession? While that’s unlikely, economically Australia certainly is the lucky country.

Real-estate has faltered and is unlikely to show real growth for many years. However, a strong economy, and with the government and Reserve Bank hell bent on supporting the real estate market, we are unlikely to see mass defaults.

Foolish take-away

There’s more than one huge reason to buy banks. Doom is priced in. Bank valuations are low. They are well capitalised.

Investors should look to start accumulating their favourite banks. We’re not talking about going all-in in one go. You have a good opportunity now, but need some spare cash should we get to see something approaching the peak of the GFC.

Those willing to focus on value and the long term growth in financial services, rather than on volatile share prices, should be well rewarded over the coming years.

Dean Morel is The Motley Fool‘s Investment Analyst. He has no position in any of the banks mentioned. The Motley Fool has a tip top disclosure policy.

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