Why you’re crazy to buy bank shares

I’ll save you the suspense and let you know why people are crazy to buy bank shares – they don’t understand them!

Apologies firstly to readers who do understand the intricacies of the financial accounts and exposures of a banking institution – I guess there must be a few people that do and perhaps they’re even reading this article. However for the most part I would suggest, few investors can claim the ability to accurately analyse banks.

A recent interview with the outstanding thinker and behavioural economist James Montier drives home the point that many investors are out of their depth when buying bank shares. Here’s what Montier – a guy who is a member of a team which runs $55 billion – answered in response to a question about investing in financial stocks.

“We tend to stay away from them (financials), too. You just don’t know what you’re buying. Their balance sheets are built the wrong way around, their assets are liabilities, their liabilities are assets, you just end up scratching your head. So generally, they end up in our too-difficult-to-understand bucket. “

It’s a candid response from an analyst who is world renowned for his insights and ability at equity valuation.

While many Australian investors are inclined to value a bank share based on its yield, this approach is only valid if you have complete blind faith in the balance sheet, regulators and management.

Based on FY 2015 forecasts, National Australia Bank Ltd. (ASX: NAB) is forecast to be trading on a dividend yield of 5.77%, making it the highest yielding of the majors. In comparison, Commonwealth Bank of Australia (ASX: CBA) is trading on a forecast yield of 5.14%, making it the lowest yielding of the Big Four.

Given the inherent risks involved with a banking enterprise this yield-based type of analysis is far from thorough and the idea that NAB may be a better purchase than CBA based simply on their relative yields is far too simplistic.

To truly have confidence that you are making a wise investment requires a sound understanding of the risks involved. The complexity of a bank makes these risks incredibly hard to judge; few investors of course are prepared to publically state that they just “don’t know”. Montier is the exception rather than the rule in this respect. But in admitting his inability, he is actually following one of Warren Buffett’s well-advised investing tenets – to stay within your circle of competence.

Foolish takeaway

A major reason investors have been attracted to bank shares has been for their high and stable fully franked dividend yields. While it’s understandable in this low interest rate environment that income-seeking investors are enticed by the banks’ yields there are a number of other blue-chip stocks which provide a combination of good yield plus capital growth and importantly have businesses models that are lower risk and more easily understandable.

Attention bank shareholders!

Fact: Australia's large banks had an incredible run in 2013. But some top analysts are saying the trend could stop dead! Get the inside scoop in The Motley Fool's brand-new FREE investment report, "What Every Bank Shareholder MUST Know."

Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.