Skip the Alibaba IPO -- Buy These Bank Stocks Ahead of Earnings Instead

NEW YORK (TheStreet) -- It seems like everyone is clamoring for the mother of all IPOs this year -- Alibaba (to be traded as BABA), an e-commerce site set to go public later this week. Most investors will probably be left out of that party.

But there are still good and underappreciated trades out there for the less-connected investor. And if you're at all risk averse, you should know that banks have risen in 11 of the past 12 months prior to reporting earnings, according to the broad-based Financial Select Sector SPDR ETF (XLF) , a financial sector index that includes banks and other diversified financial services.

Here's how to trade these stocks.

Major Holdings of the Financial Select Sector ETF:

Over the last three years, the average return of the Financial Select Sector ETF in months prior to reporting earnings has been 2.5%, or an annualized return of almost 30%. Not too bad!

September has seen a gain in the XLF ETF in six of the last eight years, with the highest return -- 4.4% -- in 2010. The return thus far this month is just 0.1%, so now may be a great entry point into the ETF's stock holdings or into the ETF itself. As the chart above shows, the biggest holdings are Berkshire Hathaway (BRK.B) , Wells Fargo (WFC) , JPMorgan Chase (JPM) , Bank of America (BAC) and Citigroup (C) .

If you buy too late, my research shows that over the last three years the risk of a loss during the month that banks report earnings jumps fourfold. Months prior to reporting earnings only had one losing month in 12, or a rate of 8%, while reporting months had a 33% rate of loss. The trend holds true over the last five years, with losses in 30% of months prior to reporting, vs. losses in 42% of months with reporting.

So what are the reasons for this trend? Disappointing earnings? Banks beating reduced earnings forecasts? Investors taking profits once banks report and don't guide higher? It could be a combination of all of these factors.

Of the largest 16 banks I cover -- and these account for two-thirds of the total industry's assets, or $10.3 trillion -- the earnings meet or beat rate over the last three years is 76%. While impressive, this was not the trend during the financial crisis of 2007 to 2009, when earnings meet or beat rates were much lower, and over one-third of these financial institutions were unprofitable. (For a comparison, the current rate of unprofitable institutions is 6.8%, as of June 30.)

Investors have come to expect more from banks going forward. Shareholders hope the economy and net interest margins eventually will improve, and they anticipate rising interest rates. Although banks have enjoyed record net profits this year, disappointing revenue growth from loans and litigation settlements have been drags on the sector.

So how should investors plan their trades?

The list below show the banks with the best chance to beat earnings forecasts and appreciate in value this earnings season. This judgment is based on reasonable price-to-book ratios, a high percentage of earning beats, minimal revisions, above average stock returns and adequate-or-better financial strength.

Best-Chance Banks

 
I would be more cautious of the following financial institutions due to one or more deficiencies. Those might be a low percentage of earnings beats over the last three years (like Northern Trust (NTRS) ), a high price-to-book ratio (as with American Express (AXP) or Charles Schwab (SCHW) ) or a low or negative forecasted stock price return over the last 12 to 15 months (as with Zion Bancorp (ZION) ).

Think Twice

 
Notes in charts on this page:

1 Stock price as of 9/15/2014

2 % of quarterly earnings meets or beats over the last 3 years

3 Price target based on low, high or average forecasted earnings per share for 2015; multiplied by the historical P/E of 15

4 Strength Rating derived from weighted averages of capital, asset quality, profitability, liquidity and stability 6/30/2014

At the time of publication the author was long C, BAC, WFC and SAN.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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