Where I come from, we call it the "idea of the cornucopia" -- meaning that it's indeed possible to have too much of a good thing. When it comes to investing, and investing in bank stocks in particular, this is admittedly a hard idea to get one's head around. But it's nevertheless critical to do so, as two of the biggest red flags for a troublesome lender are stratospheric growth, and a high return on equity.
If you follow bank stocks, then you've probably come across analysts proclaiming how one bank is better than another simply because the former has better growth and profitability metrics. I'll be the first to admit, in fact, that in my younger and more impressionable years as an investor, I, too, held a similar opinion.
My favorite example of how this can lead one astray is that of Continental Illinois, the largest commercial and industrial lender in the United States in 1981, and, at the time, the nation's seventh largest bank by assets. According to a history of the banking industry published by the FDIC:
Continental's management, the bank's aggressive growth strategy, and its returns were lauded both by the market and by industry analysts.
A 1978 article in Dun's Review pronounced the bank one of the top five companies in the nation; an analyst at First Boston Corp. praised Continental, noting that it had superior management at the top, and its management is very deep; in 1981, a Salomon Brothers analyst echoed this sentiment, calling Continental one of the finest money-center banks going.
Continental's share price reflected the high opinions of and performance by the bank. In 1979, an article noted that while the stocks of other big banking companies have hardly budged ... Continental's ... has doubled in price rising from about $13 to $27 ... since the end of 1974, compared with a 10% gain for the average money-center bank.
To give you concrete context, between 1976 and 1981, Continental's asset base grew by 111%. Meanwhile, Bank of America's (NYSE:BAC) increased by 63%, Citicorp's (the depository predecessor to Citigroup (NYSE:C)) by 70%, and Chase Manhattan (which would go on to serve as the principal banking subsidiary of JPMorgan Chase (NYSE:JPM)) grew by 72%.
And the story was the same when it came to Continental's profitability. Over this five-year stretch, its return on equity was 14.35%, which was second only to Morgan Guaranty's 14.83% among money-center banks. By comparison, Citibank's average was 13.46%, Bank of America's 13.91%, and Chase Manhattan's 11.04%.
Perhaps you already know how this story ends.
In 1984, with assets of approximately $40 billion, Continental became the then-largest bank to fail in the history of the United States. Even today, it's eclipsed only by Washington Mutual, which had a $307 billion balance sheet at the time of its demise. For those of you trivia buffs, Continental served as the initial inspiration for the phrase "too big to fail" due to the subsequent role of the FDIC.
The point I'm trying to make is relatively simple. When it comes to picking bank stocks, it's impossible to deny that spectacular growth, and return on equity, are attractive characteristics. And, to a certain extent, this is legitimate.
But in the whole scheme of things, what matters most is risk management and discipline. Look at any of the best bank stocks over the last few decades -- M&T Bank, Wells Fargo, and US Bancorp come to mind -- and this is one characteristic they all share.
At the end of the day, banking is about risk management. Not growth for the sake of growth. The sooner you absorb that lesson, the better.
John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America, Citigroup, and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.