Consumers are increasingly banking online, and many are putting their savings in branchless, direct Internet banks. This is a major shift in the banking industry, and it's a major growth opportunity for investors. I've identified two stocks that will benefit from this megatrend, including an early-stage growth story and a cheap, large bank that's a leader on the Internet.
Megatrend: direct Internet banking
The wide availability of Internet access is driving a major change in consumer preferences in banking. Each year, more and more people do their banking online. According the Pew Research Center, 18% of Internet users banked online in 2000. By 2013, that figure had increased more than threefold -- today, 61% of Internet users and 51% of U.S. adults bank online. In fact, online banking is Americans' favorite way to bank. According to a survey by the American Bankers Association, consumers prefer Internet banking to visiting a branch by more than 2-to-1. Further, an increasing cadre of consumers find bank branches unnecessary -- they can access their accounts on the Internet. Branch traffic today, as measured by teller transactions, is down more than 50% since 1995. I know I have very little use for a local bank branch. For me, going online is much more convenient.
Direct-to-consumer Internet banks cater to this growing group of consumers (like me), who are comfortable banking online exclusively. These Internet banks don't have the cost structure associated with operating physical branches, and they pass along that savings by charging lower fees and paying higher interest on deposits. This direct model, enabled by the Internet, is a win for customers and the banks. Deposits at direct Internet banks have grown three times faster than the industry over the past five years. And while clearly Internet banking is definitely on the rise, it's still relatively small compared with the overall banking sector. Only about 5% of bank customers rely on a direct Internet bank as their primary account. In other words, Internet banks have plenty of room to grow. And it's not too late for investors to cash in on this megatrend.
Bank of the Internet
BofI Holding (NASDAQ:BOFI), the holding company of Bank of the Internet, is the largest publicly traded company focused on solely on direct Internet banking. Founded in 1999, it has only a single branch in San Diego, but it has customers all over the country. It offers both business and consumer banking. Because it operates on the Internet, its operating costs a very low. Its efficiency ratio is 0.38, which is better than 93% of its peers. This allows the company to pay higher interest on deposits, while maintaining a high level of profitability. Its return on equity last year was more than 17%. And paying higher interest rates has attracted customers in droves. Last quarter, deposits grew 30%, and earnings per share increased 36%.
Of course, the company's mix of growth and profitability hasn't gone unnoticed by investors. The stock is up more than 170% year to date. Today, it's trading at premium multiples of 25 times earnings and 3.8 times book value. If Bank of the Internet continues its astounding growth, those rich multiples are probably justified. But even a small hiccup could result in a big share-price drop. So there's some valuation risk. It is also a new, relatively small bank with plenty of larger competitors. And direct Internet banking, as an industry, is still in the early stages. So there's also business and execution risk. I believe the opportunity justifies the risks of investing in Bank of the Internet. But I've sized my position to reflect the high-risk, high-reward profile.
If investing in a high-multiple growth stock like Bank of the Internet doesn't appeal to you, consider Capital One Financial (NYSE:COF) for exposure to growth in Internet banking. Capital One is the sixth largest bank in the U.S. based on assets. It is best known for its credit card businesses, but it also offers consumer and business banking. In 2012, it closed on a $9 billion deal to acquire ING Direct USA, the largest, most established Internet bank, with $84 billion in deposits. ING Direct USA has since been rebranded as Capital One 360, and its Internet deposits represent an estimated 40% of the bank's total deposit base. So Capital One should benefit from the growth in direct Internet banking.
Of course, Capital One 360 (the direct Internet bank) is only a portion of Capital One's overall business. You'd also need to be comfortable with its other businesses and management. Based on its size alone, Capital One is highly unlikely to grow at the same rapid clip as Bank of the Internet. But Capital One is quite a bit cheaper at 10 times earnings and less than 1 time book value -- not bad for a profitable, well-run, and well-capitalized bank. And Capital One pays a 1.7% dividend, which management plans to increase going forward. Overall, Capital One could turn out to be an excellent long-term investment, even if it lacks the upside potential of Bank of the Internet.
Foolish bottom line
Obviously, the future of direct Internet banking is unknown, but the opportunity seems massive. According to an Accenture study, direct Internet banks could claim 15% of traditional banking revenue by 2020. If that's the case, both Bank of the Internet and Capital One should benefit significantly.
Brendan Mathews owns shares of BofI Holding and warrants of Capital One Financial. The Motley Fool recommends and owns shares of BofI Holding. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.