7 Small Banks That One-Up Wells Fargo

At the Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual meeting, Warren Buffett dropped a bomb when he said that he would have gone all-in on Wells Fargo (NYSE: WFC  ) at the March lows. That certainly got my attention and prompted me to ponder what makes for a killer banking franchise.

Every bank will eagerly tell you how special it is, pointing to everything from its conservative lending standards to its superior customer service. Sometimes, these claims happen to be true. But in my eyes, banking is a fairly commoditized business. If that's the case, then what works for folks like EOG Resources (NYSE: EOG  ) in the oil patch, Wal-Mart (NYSE: WMT  ) in retail, or GEICO in the auto insurance realm ought to work in the banking business as well.

In other words, the low-cost producer wins. That's exactly the status that Wells Fargo boasts among the big banks, with rock-bottom borrowing costs of 2.25% last year. Wells' ability to source low-cost deposits contributes directly to a fat net interest margin and indirectly to some historically strong returns on equity.

Going on a bank safari
Even back in 1990, the first time Buffett wrote about Wells Fargo in one of his annual letters, the bank was already quite large, with $56 billion in assets. So, this big bank was already a great fit for Buffett, who needs to bag elephants in order to move the earnings needle at Berkshire. The rest of us are free to hunt for smaller game, however, and that's exactly how you'll find banks that sport both lower borrowing costs and higher net interest margins than Wells.

In fact, a recent search along these lines turned up exclusively small cap banks, with none exceeding $2 billion in market capitalization. Here are the seven largest:

 

Total Cost of Borrowings (%)

Net Interest Margin (%)

Westamerica Bankshares (Nasdaq: WABC  )

1.29

5.13

SVB Financial (Nasdaq: SIVB  )

2.08

5.78

First National Bank Alaska

1.2

5.45

Hudson Valley Holding

1.99

5.14

Capital City Bank Group

1.87

4.96

Bank of Marin

1.7

5.41

Tri City Bankshares

1.83

4.97

Figures are for calendar year 2008. Data provided by Capital IQ.

To be clear, no single metric makes a stock a must-buy. Just as an oil and gas company could have low finding costs but a poor liquidity position, any of the above banks could have made some bone-headed lending decisions over the last few years that would totally negate the competitive advantage bestowed by these low borrowing costs. Buffett likes Wells not only for its cost of funds, but for the way it adroitly deploys those funds. The firm's robust non-interest income isn't captured in the funding cost metric, either.

Here's an example of where an exclusive focus on borrowing costs could cost you dearly. Capital City has seen its non-performing assets (NPAs) run up to 6.4% of loans and other real estate, triple the percentage reported just a year ago. The company believes itself to be "dedicating sufficient resources and talent to understand, monitor, and eventually resolve" its red-headed stepchild loans. Whether the firm ignored the risks to its loan book, or flat-out failed to perceive them (as seems to be the implication here), neither is a very satisfactory state of affairs. The shares have been cut in half this year.

Despite the potential pitfalls, there are some promising bank stocks elsewhere on this list.

Minting money in Marin
Both of the Marin County, Ca.-based banks look pretty attractive to me. Westamerica, for one, has a record of extraordinarily tight non-interest expense control. The firm's efficiency ratio weakened in 2008, but that was solely as a result of falling revenues rather than any cost creep. This bank sports the highest pre-tax earnings margin out of the bunch. My biggest complaint would probably center on Westamerica's slow loan growth, but acquisitions of failed competitors like County Bank ought to help with that. Bank of Marin, meanwhile, has been growing at a nice clip, and it is the only bank on the list that's compounded its book value faster than Wells over the past seven years. Bank of Marin also sports the second-highest pre-tax margin.

Over the counter, overlooked
A few of the other banks on the list are traded over-the-counter and are extremely illiquid (i.e., less than $200,000 worth of daily trading volume), so I'll leave the exploration of those names to my more intrepid readers. I will say that Tri City, a Milwaukee-area community banker, is notable for its crystal-clear financials and its founding family's big ownership stake, if you go for that sort of thing.

More Foolishness:

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Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. Berkshire Hathaway is also a Stock Advisor recommendation. The Motley Fool owns shares of Berkshire Hathaway and has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 26, 2009, at 2:59 PM, PricePro12 wrote:

    Wells fargo is a dieing branch. It always has, always will be.

  • Report this Comment On May 26, 2009, at 4:22 PM, TMFBreakerRob wrote:

    Fine article, Toby, and kudos for thinking beyond Mr. Buffett's immediate focus on WFC. This have given me something to think about....perhaps leading to an expansion of my watch list. ;)

    Rob

  • Report this Comment On May 26, 2009, at 9:43 PM, Netteligent09 wrote:

    Well Fargo is one of the Worst Bank in 2010. Economy.com expects that 60 percent of the mortgage defaults this year will be set off primarily by unemployment, up from 29 percent last year.

    Mortage toxic is back with vengeance. But in the coming quarters, the scenario will play out with other exotic mortgages, Option ARM (pick-a-pay), Alt-A, etc. The homebuyers may have had better credit, but they had the same strategy: Get a low interest rate upfront, and then deal with the reset down the road, by either refinancing or selling the home.

    But, whoops, home values are way lower and the economy sucks. Plan derailed. Well Fargo is right in the middle of next wave of foreclosure.

  • Report this Comment On May 26, 2009, at 11:53 PM, kellogg9 wrote:

    I was reading a piece the other day about WF not being so great. It may still be here 5-10 years from now but i strongly doubt it will be in the same style that it is today.

    Kelly

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