Twas the Night Before Earnings

As the quarterly reports begin to cycle in, the week will begin with big names like Wells Fargo (WFC 2.73%), and J.P. Morgan Chase (JPM 0.65%).

While Bank of America (BAC 1.53%) endeavors to put legal woes in the past, the bank's returns are still in the single digits. Yet one has to wonder if the harsh reality of low interest short-term lending has crippled the banks where they need the most support. As the week presses on and numbers are reported, will any of these immense institutions shock us with unexpected gains?

A full transcript follows the video, recorded on Monday, July 13, 2015.

Kristine Harjes: 'Twas the night before earnings. This is Industry Focus.

Hi, everyone. Welcome to Industry Focus: Financials edition. I'm your host, Kristine Harjes and I'm pleased to welcome back to the show our senior banking analyst; John Maxfield. The big buzz in the banking sector right now is -- you guessed it -- earnings. Tomorrow, July 14^th, earnings season will kick off for the U.S.' biggest banks.

Up first we'll get a peek at Wells Fargo and J.P. Morgan's performance over the last quarter. On Wednesday we'll hear from Bank of America, and then Thursday we get Citigroup (C 0.26%) and Goldman Sachs (GS -0.20%).

Before we talk about any specifics let's back up a little bit. John, I'm a long term buy and hold investor. Why should I care about quarterly performance?

John Maxfield: On one hand you could say quarterly performance doesn't really matter because these are just snapshots. They're not a dynamic show of what a business or bank is doing. You're just going to get bits and pieces -- four of these -- a year. In that perspective maybe you shouldn't care.

However, these are benchmarks that you can follow intermittently along the way to see how the companies you've invested in are doing. It's an update in terms of what this bank is doing with your money. From that perspective it's very important.

Harjes: What metrics should investors be looking for, besides the obvious earnings?

Maxfield: When it comes to banks you want to look at the things that impact its income statements. You'll want to look at revenue. How are their loan origination volumes going? How is their M&A activity going, when you're talking about the big universal banks that are based out of Wall Street?

You want to look at the topline, then you'll want to look at the loan loss provisions. How much are they setting aside for bad loans this quarter? How much did they set aside last quarter? How much did they set aside the quarter before that? You're going to want to look at their net interest income. This is how much money they earned from their asset portfolio. Banks make money, in principal, one way. They borrow a bunch of money at cheap, short-term interest rates from depositors and other types of warehouse lenders and then they reinvest that money into interest earning assets.

The money and earnings that come out of that is call net interest income. You're going to want to watch the direction of that; and that's going to probably be relatively low on a historical basis because interest rates are still so low. All those are on your income side. Then you also have non-interest income from fee based services. On the other side of the income statement you have your expenses; particularly your efficiency ratio, which shows how much it costs to raise every dollar of revenue.

If your efficiency ratio is 60% that means it costs $0.60 to raise every $1 of revenue. If you can look at both your earnings, and go through your revenue components -- your non-interest income, your net interest income -- and then you hit your expenses with your operating expenses an your provisions for loan losses and watch the trend in those components; that will give you a pretty comprehensive view of how a bank is doing.

Harjes: In terms of these trends what do you think matters more; comparing these benchmark numbers to prior quarters, or comparing them across the industry to competitors?

Maxfield: I think both actually matter quite a bit. A prior quarter basis is important because every investment you make needs to grow to justify the multiple on its stock. It's important on growth basis, but in terms of picking stocks within an industry it's important to look at different types of banks. Let's talk about Wells Fargo versus Bank of America. You look at Wells Fargo and they generate a ton of revenue relative to its assets and it keeps expenses low.

Whereas Bank of America's expenses are really high, and because of all the things it's been going through since the financial crisis; it's struggled to get its revenue back up and going again. What that leads to is a much higher return on investment for Wells Fargo than it does for Bank of America. That's something shareholders need to know.

Harjes: That makes sense. Looking at the broader industry, what sort of specific headwinds, or tailwinds, or key drivers to keep an eye on going into this earning season?

Maxfield: I would say the biggest headwind right now are still interest rates. Let's go back to the late '70s, early '80s. Short-term interest rates shot really high because we were dealing with double digit inflation. What that led banks to learn was you can't just borrow low, short-term interest rates and then lend at higher long-term interest rates. In that situation you can get caught in "mismatch", where it's costing you more to borrow money than you're generating on those investments from that money.

What they did is started indexing all their loans -- or the majority of their commercial loans that they keep on their books -- to short-term interest rates. So now it's just LIBOR plus 2.5%, or LIBOR plus 3%. You want a higher short-term interest rate to boost your revenue. That's one of the main tailwinds right now because since the financial crisis, interest rates have been effectively 0% for all intents and purposes.

That's probably the biggest headwind the industry is facing right now. In terms of tailwinds, because the market seems to be calmer this quarter, we're probably going to see a better trading revenue, we'll probably see better M&A revenue; all those things that a universal bank could bring to the table. Those things are probably going to be doing pretty well.

Harjes: How do you think the Greece situation is going to play in?

Maxfield: That's a great question. It seems like they've come to some type of agreement. That's a positive thing, but where Greece would factor into U.S. bank earnings is probably in the volatility that it caused in the markets. In most of the U.S. banks have drawn down their direct exposure via their operations -- actually having operations in Greece -- or by making loans, or holding deposits to Greek citizens or corporations.

Most of the banks that have reported over the last year have said "We're drawing this way down." It's probably going to be in that trading revenue where you'll see the impact. The other thing that Greece could impact is the Federal Reserve's decision to keep interest rates low for an indefinite period of time.

Harjes: That's a good point. Let's pivot a bit to more specific individual banks. What bank do you think has the best chance of surprising people? Either to the upside, or to the downside.

Maxfield: That's a great question. It's been my thesis that Bank of America is probably in a position to normalize its earnings. When you look at Bank of America today it's earning 3% or 4% on its equity, and you want a bank to earn anywhere from 12% to 15% on its equity. So they're way down. It's down because of all the issues it's dealt with since the financial crisis, but particularly the legal issues. This has cost them somewhere near $90 billion for the write-offs on Bank of America's books over the last few years.

Once these are through, Bank of America's earnings should clear up and normalize. My guess is that will happen relatively quickly once that upward trend begins. I could be totally wrong on that, but if you look back on Bank of America's experience in the 1980s when it went through trouble, as soon as those troubles were over -- I think it had three successive years of losses -- but as soon as those losses were over its earnings shot way up, really quickly to new record highs. Not just record highs even.

I think it was earning around $500 to $600 million a year prior to its three successive years of losses. Then three to four years after that they were earning $2.5 billion a year. Once that begins, it happens relatively quickly. I would say, in terms of surprises, Bank of America is going to surprise us. Is it going to be this quarter? I have absolutely no idea, but it will be at some point.

Harjes: I'm sure their investors would very much like that, considering they're down 5% year to date. Hopefully, if you're a Bank of America investor you'll get some positive news this week. On the flip side of that, who are we already expecting is just going to kill it this quarter?

Maxfield: That's another good question. Due to the low interest rates and the impact that has on bank revenue, I don't necessarily expect any banks to "kill it". I could be wrong, of course. You could have another stellar performance from Wells Fargo. Over the last 19 quarters, Wells Fargo has recorded record earnings in 18 of those quarters. That's pretty remarkable, but the one quarter it missed was the most recent quarter before the one they're reporting on this week.

The question is: will Wells Fargo report another quarter of declining earnings because of the impact of short-term interest rates, or will it be able to use its 90 other businesses, it's vast diversification to get on that upward track again? That's going to be the big question in terms of Wells Fargo. If you're going to look for a bank that has a stellar performance, that's probably the one you'll want to be looking at. Maybe US Bancorp (USB -0.20%), and then J.P. Morgan Chase, which is a phenomenally run bank.

Jamie Dimon is probably one of a handful of the best bankers in the world right now. It not only has a really good consumer commercial business banking side, but it also has a really good investment banking side as well.

Harjes: Of course, we've talked about just how important that management team is to a bank.

Maxfield: That's exactly right. You can say what you want about J.P. Morgan Chase; they've gotten themselves in a lot of trouble over the last five or six years. There were the allegations about the manipulation by their traders and energy markets, foreign exchange markets, interest rate markets, etc. At the top of this bank is a phenomenal banker. He surrounds himself with people of the same pedigree as well.

Harjes: I've got a fun question for you. It's a "would you rather". Would you rather be a bank that's expected to post stellar earnings and fall just shy of these anticipated numbers, or would you rather be expected to have a total flop of a quarter and actually exceed expectations slightly?

Maxfield: That's a great question. I'm not a big fan of analyst expectations, in terms of 'pegging' the actual numbers. There's a theory around earnings season that banks miss, or beat expectations. That's absurd. When you think about it, it's the analysts' expectations that are inaccurate in this whole scenario.

Harjes: Yeah.

Maxfield: I'm not a big expectations person, but let me tell you this; when you're looking for a bank stock to buy, what you want is one that you can trust, one that will generate double digit return on equities for many decades. That brings into the equation that compounding effect of compounding returns. That's the way that you get your 1000% returns, your 2000% returns.

Betting on a quarter by quarter basis whether a bank is going to beat, or miss earnings expectations, even if you bet correctly, and if you leverage that up by using various options like calls, or puts that dramatically increase your leverage on a bet; even if you do that and bet correctly you're still not going to get anywhere near the return that you're going to get if, over time, the law of compounding returns plays a role in.

Harjes: That is our Foolish mentality. You want to buy the best banks and hold onto them forever.

Maxfield: That's exactly right. This is something I've talked a lot about in articles in the past. When you're selecting a bank, because of this reason, you've got to look at the probability that it will not only survive through the next crisis -- which could be 10 years, or 20 years down the road -- again, if you want the law of compounding returns to kick in and give you phenomenal returns you've got to factor that into the equation.

So you've got to look at the banks that have done well in past crises as a slight indicator of how they will do in a future crisis. If a bank has done well, or done really poorly in a past crisis, is that a better chance or worse chance that they'll do well in the next crisis? I'd say there's a pattern developing, so you're going to want to avoid that type of bank.

Stick with your Wells Fargos, your J.P. Morgan Chases, your US Bancorps; those that have shown time and time again that they can not only be profitable in good times, but can also survive and thrive through bad times as well.

Harjes: Hopefully this coming week will give us an opportunity to check in with some of these top performers and make sure the investing thesis behind them is still just as much intact now as it was when we initially made our investments, or if we aren't in yet, give us a good opportunity to get in. John, thanks so much for being here today. All we can do now is sit tight and wait for tomorrow morning, try to keep cool heads and invest -- capital F -- Foolishly in banks that are these proven outperformers.

Listeners, who are you keeping an eye on going into earnings seasons? Let us know at [email protected]. We love hearing from you guys, answering your questions, just hearing what's on your mind. Until next time, reports are coming out all week. Happy reading! As always people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So, don't buy or sell stocks based solely on what you hear.