The 2 Best Stocks for Investing in Regional Banks

U.S. Bancorp Tower in Portland, Oregon. Source: Wikimedia Commons.

If you're on the hunt for the best stocks for investing in regional banks, let me do the work for you: The two best regional bank stocks to invest in are U.S. Bancorp (USB 0.05%) and M&T Bank (MTB 0.98%).

Here's why.

A quick note on valuation
By no means are these the cheapest bank stocks. In an industry where most stocks trade for 1 to 1.5 times book value, shares of U.S. Bancorp are currently valued at 1.98 times their book value, while M&T Bank is selling for a more reasonable 1.48 times book. So if you're looking for the least expensive bank stocks to buy, then you'll have to go elsewhere -- say, the megabanks Bank of America or Citigroup, which trade for double-digit discounts to their respective book values.

As I've discussed in the past, however, it's a mistake to buy bank stocks based on valuation alone. I say that because the difference between the best-run lenders and the rest is huge. Thanks to the extreme leverage inherent in the banking-business model, even small errors can lead to outright insolvency. That's why 500 banks have failed since the onset of the financial crisis. And even the ones that didn't fail, such as Bank of America and Citigroup, so thoroughly diluted their shareholders that it will take years, if not decades, for investors to recoup their losses.

One number every bank investor needs to know
With this in mind, the proper objective when picking a bank stock is to buy the best, not necessarily the cheapest. In doing so, there's one statistic that matters more than any other: the efficiency ratio. This ratio measures how much of a bank's net revenue is consumed by operating expenses. The larger the number, the less revenue is available to set aside for future loan losses, to pay taxes, and to distribute to shareholders through buybacks or dividends.

This metric is important for the simple reason that a bank with a low efficiency ratio necessarily has a wider profit margin. But even beyond that, a low efficiency ratio matters because more efficient banks also have a tendency to underwrite better loans than their less efficient peers. The former don't have to reach for yield in their loan and securities portfolios to achieve a satisfactory return on equity.

Columbia business school professor Charles Calomiris touched on this relationship in his book Fragile by Design: The Political Origins of Banking Crises & Scarce Credit: "Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind."

It accordingly follows that if you can identify banks with a long history of operating efficiently, then you've gone a long way toward finding the type of bank stock that will generate outsized returns in the years and decades ahead. And it's for this reason that I believe U.S. Bancorp and M&T Bank are the two best stocks for investing in regional banks. Not only did they operate more efficiently than their peers during the credit cycle that includes the financial crisis of 2008-2009, but they've also generated the best shareholder returns over the past three decades:

Source: S&P Capital IQ and YCharts.com.

The lesson here is that regional banks are like any other business: The ones that are the most shrewdly managed -- as evidenced by a low efficiency ratio and a correspondingly high return on equity -- are the ones that offer the best chance of outperforming both their competitors and the broader market. And few have proved their worth in these regards more than U.S. Bancorp and M&T Bank.