6 Signs of an Investment Worth Banking On

If you're interested in investing in regional banks, you'll want to know the right way to measure their merits. At The Motley Fool, we're big fans of using investment checklists to help us make smarter decisions about stocks. Here's a checklist covering six key areas that can help you find better stocks in the regional banking industry. 

1. Capitalization
Your primary concern when checking out a regional bank is whether the company has sufficient capital to operate. Capital refers to a bank's net worth: the difference between assets and liabilities. A simple metric to look at is total equity to assets, which you generally want to exceed 10%. You can find the necessary numbers to calculate this in the company's balance sheet. This is even more important in times of crisis, since banks with minimal capital levels will be more likely to fail.

For example, in the year leading up to the financial crisis, The First of Long Island Corporation (NASDAQ: FLIC  ) had an equity-to-assets ratio of 10%, while Citigroup's ratio was 6%, and we all know how that turned out. The company's prudent management of capital paid off since the company maintained a solid liquidity position during the financial crisis.

2. Underwriting
Next, you'll want to make sure you understand the riskiness of a bank's loan portfolio. You're probably familiar with the concept that given increased risk, investors should demand higher returns. Just looking at a bank's return on its loan book won't tell you the whole story, though; you also need to know whether the bank's making enough on those loans to compensate it for the risks it's taking. Yield on earning assets is an easy way to get an idea on what the bank's return on its loan book is. You can calculate this by taking interest income and dividing it by the value of earning assets -- loans, investment securities, etc.

As an investor, you also want to find lending institutions that can accurately judge the quality of the clients they lend money to. This is another tenet to being a responsible underwriter. An easy way to analyze this is to look at the bank's nonperforming loans (the folks not making loan payments) as a percentage of total loans. The lower this ratio, the better, and looking at this figure over several years can tell you whether the bank's headed toward a safer or riskier portfolio.

3. Operating history
Three things come to mind when picturing a smoothly operating bank: deposit growth, cost of loanable funds, and opportunity. Generally speaking, you'd like to see deposit growth exceed inflation over the long term. This is the main source of loanable funds for banks, so the more deposits they can accumulate, the more loans they can make, and the more interest income they can earn. Make sure to consider the source of deposit growth, too, to better understand the cost of the bank's loanable funds. For instance, a bank growing its deposit base through non-interest-bearing accounts should see its cost of funds decline over time, as the low-cost funds become a larger portion of the total.

Lakeland Financial Corp. (NASDAQ: LKFN  ) is a great example of deposit growth in excess of inflation. Since 2009, the bank increased deposits by almost 6% annually, well above inflation over the same period. The majority of the growth was organically generated. For instance, the bank increased its non-interest bearing demand deposits by 11% in 2012, and has been very quiet on the acquisition front.

As for the bank's lending opportunity, looking at the ratio of total loans to total deposits -- money lent out versus money taken in -- will give you some general insight into what the bank can do. On average, you'd expect this ratio to be around 100%; however, this isn't always the case. A ratio above 100% indicates a rather aggressive bank, while the sub-100% lender leans more conservatively. Furthermore, banks under 100% might have a larger lending opportunity in front of them given their higher capacity.

4. Profitability
Profitability is important for all companies. With banks, return on assets (ROA) tells us how much net earnings are recorded per dollar of assets on the balance sheet. Recent Federal Reserve data reports the average ROA for all U.S. banks to be around 1%. Using this as a benchmark will help us filter out below-average lenders. Another metric you can look at is net interest margin, which divides net interest income -- interest income less interest expense -- by average earning assets. This can fluctuate among banks based on different operating characteristics, but looking at this over an extended period and relative to competitors will give you a deeper look into the bank's profitability.

TFS Financial Corp (NASDAQ: TFSL  ) has a five-year average net interest margin of 2.3%, while Texas Capiral BancShares' (NASDAQ: TCBI  ) five-year average is 4.3%. The reason for the disparity is TFS operates as a plain vanilla lending institution with the majority of its earning assets comprised of residential mortgages. Texas Capital's loan book is more evenly spread with a higher concentration in commercial loans, which are often not secured by physical assets.

5. Valuation
Valuing a bank can take an extraordinary amount of time, more than many investors are able to spend. However, valuation is integral to determining future returns, so don't ignore it. To get a rough idea of future returns, consider your company's price to book value and price to tangible book value relative to those of competitors, and take into account the quality and opportunity of the bank. This might be worth paying a little extra for, as in the case of Access National Corporation (NASDAQ: ANCX  ) , which has historically traded at a slight premium because it's extremely well run. Management consistently delivers great returns on assets and equity, and the bank has always been properly capitalized.

6. Strategy & Management
Speaking of management, look for a team focused on producing strong returns with incentives to match. Beware of situations where management compensation is tied to loan growth.

A good management team seeks profitable business; when managers get paid based on the bank's investment returns, shareholders have more reason to believe their investments are safe. Also, look at leadership's capital allocation decisions and how that reflects their attitude toward shareholders. Turning down business can actually be a shareholder-focused move, if that business could have destroyed value. Prudent management extends credit to drive profits and growth in book value; on the flip side, bad loans reduce profits, book value, and shareholder returns.

And don't overlook strategic analysis. Has the bank used a wise strategy in the competitive market? Does it dominate a particular region? Has it introduced new, successful products? Also, look into customer loyalty. Some of the best banks will be able to cross-sell their products to existing customers. Some banks may report this information in their annual filings, while others won't, so do the best you can. Finally, for any bank that dominates a region, you should get an idea of the demographics of that region to better understand the bank's customers. Things to look at would be household income, dominant industries, home ownership rates, etc.

The Foolish bottom line
Banks can be difficult to invest in; however, by focusing on the things I mentioned here -- capitalization, underwriting, profitability, valuation, and strategy and management -- you will get a much better idea of the basic qualities of each bank you look at.

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