Bank Stocks in 2015: New Year, New Opportunities?

What does the banking industry have in common with the airline industry? More than you might think! Foolish analysts Michael Douglass and John Maxfield delve into what lies ahead for the banking industry as we enter the new year, and what investors should look for when choosing bank stocks.

And what about interest rates? Everyone knows the Fed may be boosting short-term interest rates, but what's the reasoning behind it, and which companies are most likely to be affected? Tune in to find out.

A full transcript follows the video.

Michael Douglass: Banking in 2015 and a leveraged loan market; this is Industry Focus...

Hi Fools, financial analyst Michael Douglass here with our senior banking specialist, John Maxfield, from Portland. John, how is it going?

John Maxfield: It's going great. Happy New Year to you, Michael.

Douglass: Happy New Year as well. I feel like I'm a little bit late to the party! I just got back from vacation, so I've been wishing everyone a Happy New Year and they've been looking at me like, "Well, it's a few days into January now, Michael. That's getting old." I guess that's how it goes!

Do you have any new year's resolutions, John?

Maxfield: It's horrible, but I haven't made any new year's resolutions, I'm sorry to say.

Douglass: My first one was to start swimming again, which is followed up by a second one, which is to find a way not to smell like chlorine. That's on my to-do list.

All right, let's jump right in; bank investing in 2015. Let's just break this down. What are the major things that people should be looking for in banks this year?

Maxfield: 2015 is really not unlike any other year.

Douglass: Right.

Maxfield: There's a tendency, when you're crossing over from one year to another, to say these are the things that you should be looking out for, for this particular subset of stocks this upcoming year.

But really, the calendar is somewhat of an artificial demarcation point, that switching over from one year to another. It doesn't change the fundamental dynamics of banking, so it's just really the same thing that we've been talking about, Michael, over the last few months.

It's about finding the best banks, who are really good at managing credit, who run efficient operations, who treat their employees and their customers well. Presuming that they trade for a reasonable multiple -- which a lot of them don't right now -- but if you can pick them up at a reasonable multiple, those things should result in superior returns, relative at least to the industry.

Douglass: Right. People are going to want to be looking really closely at that efficiency ratio, and then also more broadly -- it's kind of a squishier concept a little bit -- this good credit lending culture.

How do you approach figuring out what that looks like? Is it through the lens of the efficiency ratio -- because I assume that's your starting point? Then how do you look at that squishier topic?

Maxfield: What I would recommend is this. If you're even remotely considering investing in a bank, what you need to know is how well their asset portfolio has a tendency to hold up during downturns in the credit cycle.

Really, the only way you can figure this out is by looking historically at how these asset portfolios have performed in the past. Obviously the most recent experience, and one of the worst experiences we've had -- over the last century, for that matter -- happened in 2008 and 2009.

What I would recommend to investors is that you go back to 2008-2009, look at how that asset portfolio at this prospective bank that you're looking at, performed. If it did poorly -- and the measures you're going to want to look at are things like net charge-off ratio, the non-performing loan ratio, things like that; there are a whole bunch of credit metrics that you can look at.

You can look at the percent of revenue that is being consumed by provision for loan losses; a whole bunch of different things. The point being, how that asset portfolio performed, and is expected to perform in future cycles, will dictate the underlying returns of a bank.

Douglass: All right, fair enough. I think that's some pretty good, solid advice. Of course the issue is that the better banks do tend to trade at higher multiples. I'm assuming you don't really see any particular value options there, among the better ones, the Wells Fargos (WFC 2.73%) of the world?

Maxfield: Yes. Two points to follow up on what I was saying just a second ago; there is no guarantee that the way a bank will perform in the next cycle is tied to the way that it performed in the last cycle.

However, that is the best piece of evidence that we have, when it comes to how they manage credit risk. There's no guarantee, but that's the best that we have.

Douglass: Yes.

Maxfield: In terms of the really good banks, that do well at managing credit risk -- you have your Wells Fargos, your U.S. Bank (USB -0.20%), your M&T Bank Corp. (MTB 0.19%), New York Community Bancorp (NYCB -0.67%). All of these banks trade for high multiples to book value, and that is to be expected.

If you're buying a Mercedes, to use an analogy, you're going to pay more for that car than if you're buying, say a Honda Civic. You have to expect to pay more for these stocks, but you're going to get a larger return from them over the very long run.

Now, that is not to say that you should go out and be spending 2.5-3.0 times book value on a stock like US Bancorp. Even though it's an excellent bank, what we've found is that if you look at past returns, really the only way to beat the S&P 500 by investing in bank stocks is to buy them when they are cheap.

Let's say you can pick up a U.S. Bancorp at, say 1.0 times book value or 1.25 times book value, or somewhere like that. If you can do that, you're going to do really, really well over the long term.

Douglass: All right, makes sense. Actually, I'm glad that you mentioned an analogy, because another analogy that you've been talking with me about a little bit has been this idea of banks being like airlines. Let's talk about that a little bit, because these are two very, very different industries, and I think people would be curious to see how you're comparing these two to each other.

Maxfield: If you go back and you look at the airline industry, what's that famous Warren Buffett quote? The airline industry, in aggregate, hasn't made money since the Wright Brothers invented the airplane, pretty much!

Douglass: Which sounds a little bit like what some people have said about the banking industry, right?

Maxfield: That's exactly right. Nassim Taleb has said basically that exact same thing about the bank industry.

Let's be clear; finding the data that can conclusively back this up one way or the other for either the airline industry or the bank industry is impossible. I, personally, think that it's impossible. I've spent a number of hours looking for this data.

However, the mere fact that it's even a topic of conversation would suggest that it's probably in that gray zone where, as a general rule, neither of these industries are very profitable over the long run.

One of the problems with the airline industry, that we've seen over the last few cycles, is that you have Southwest Airlines (LUV 0.97%) come in, and they're a disruptor, and they disrupt by using a very low cost model, which allows them to charge their customers less for plane tickets.

Plane tickets nowadays are a commodity, so if you're the low cost producer and if you can price your tickets at the lowest level, you're going to suck up a lot of that good volume from the industry -- and we're seeing that. How many airlines have gone bankrupt over the last decade? Almost all the major ones.

You can think about banks somewhat like retail companies, or a company that sells anything. Banks sell loan, and the price of a loan is the interest rate.

A bank that can sell a loan at the lowest price -- i.e., interest rate -- is going to suck up a lot of the good volume in the industry, and that's exactly what we're seeing with the Wells Fargos, the US Bancorps.

Banks like that, that are able to operate really efficiently -- so you have your efficiency ratio south of 60%, and in some cases you can even get them south of 50% -- they're able to write these loans at really low interest rates, relative to their competitors.

What that means is that they can go out and get the top-notch commercial and industrial loans in the market right now, and that leaves all the "slop" if you will, for your Bank of Americas (BAC 1.53%), your Citigroups (C 0.26%); all these other larger banks that aren't as efficient and aren't able to compete on the loan prices to the same extent that US Bancorp and M&T Bank, New York Community Bancorp and Wells Fargo are able to do.

It's that dynamic, that low cost producer dynamic, in an industry where you're selling a commodity, i.e. money, has a tendency to really bifurcate those few good low cost producers form the rest of the pack.

Douglass: Of course there are going to be some differences from the airlines though, right? When you look at a Frontier, for example; I've flow Frontier recently and you get charged for a lot of different things that maybe some of those other carriers aren't going to charge you for, so the actual cost beyond that ticket price is going to be a little bit different.

Whereas, with a loan, if you're able to get a 10 year loan at one bank for let's say 6% APR, then at another bank you're getting a 10-year loan for a 5% APR, those loans are essentially the same assuming that they're the same size. So, I don't think the analogy works perfectly, but I think that there's a definite connection there in terms of low cost providers providing a disruptive opportunity for people.

Maxfield: What I would say about that though, Michael, is that when you look at buying an airplane ticket and you have all these ancillary costs associated with it, so your original cost may be very different than what it eventually turns out to be when you add in -- maybe you upgrade, maybe you buy a meal...

Douglass: Amounts of leg room, stuff like that.

Maxfield: Yes, so you actually have some leg room! Maybe they'll just start making us stand pretty soon, right?

Douglass: There's a thought!

Maxfield: In the banking industry, it's important to not just look at a single loan. You have to look at the relationship in general as well, because a lot of these banks are able to make loans, get deposit accounts, and then build out that relationship.

When you're building out that relationship, there are -- just like in the airline industry -- innumerable ancillary costs again, to the consumer. You have overdraft fees ... just a whole assortment of fees that bank consumers have unfortunately become too familiar with over the last few years.

When you look at it in an aggregate relationship, it really isn't that different from the airlines when you're considering this dynamic where you have the entry-level fee, and then the ancillary fees on top of that.

Douglass: Fair enough. Let's turn then to the leveraged loan market, our final topic for today.

It has been common wisdom, common sense, that the Fed's going to raise short term rates, for a little while now, and of course that could impact a number of stocks that we cover here in the financial space.

But first let's back off one from that and just explain why exactly is the Fed potentially looking at raising short term interest rates?

Maxfield: Sure. If you go back to the financial crisis, what we see is that when the credit markets go through a situation where they're seizing up, one of the things that the Federal Reserve can do is they can lower those short term interest rates, which theoretically will boost lending. The opposite side of that obviously is borrowing. By boosting borrowing and lending, you're going to theoretically boost the economy.

The problem is that you can only do that for so long before it theoretically triggers inflation, and the fear is that -- and we have seen absolutely zero evidence of inflation thus far, and that's the reason the interest rates have stayed so low -- but the fear is that at a certain point that inflation is going to be triggered by these ultra-low interest rates.

The thought process is that we're now in that area where we've seen unemployment come way, way, way down; it's now under 6%. Inflation's still holding steady, in between 1%-2%, but the Fed wants to stay out in front of that, and the way they do that is they'll boost up those short term interest rates.

Douglass: Got you. Definitely makes sense. Then when we're thinking about these short-term interest rates, who do you see as being the most potentially affected?

Maxfield: At the beginning of last week I had a conversation with a president of one of the largest -- I think it is actually the largest -- business development company. What business development companies do is, for the most part, they hold the loans -- they invest in loans -- that come out of leveraged buyout transactions.

You have a company that's going to buy another company, and what they do is they leverage the purchasee company's assets up by bank loans or bonds, junk bonds, things like that. BDCs will come in and they'll buy those loans in the middle there, that are actually really, really risky, that come out as a part of these leveraged buyout transactions.

He was telling me, "Look. The dynamic right now in the BDC market is really good, because we're going to see interest rates tick up but all the BDCs, their loan portfolios to these leveraged vehicles, these leveraged companies, they're all indexed to interest rates."

The theory is that the BDCs are going to be protected because, when the interest rates go up, their portfolio will just go up. The problem is that a lot of these companies that these leveraged loans have been placed upon don't have a lot of wiggle room if interest rates go up, because their interest payments are already so large.

We've seen this many times in past cycles. When those interest rates go up, they will tip a number of these highly leveraged companies into bankruptcy. If they tip those into bankruptcy, then that will come back in to the BDC market and banking market, and things like that.

It's for that reason that the federal bank regulators have been really stringent on banks over the last six months about cleaning up their leveraged loan exposure.

Douglass: Certainly an issue we'll want to be watching very closely, moving forward.

John, as always, thanks for your time. Folks, check back to Fool.com and of course the Industry Focus Podcast for all of your financial and investing needs. After all, we are where the money is! Thanks much, and Fool on!