Richard Davis is one of the greatest bankers of the modern era. As CEO of U.S. Bancorp (NYSE:USB) since the end of 2006, Davis has spent the last decade atop the most profitable big bank in America.
In this week's episode of Industry Focus: Financials, analyst Gaby Lapera teases out the most interesting insights that Davis, who retires next month, shared in a wide-ranging interview with Fool contributor John Maxfield.
A full transcript follows the video.
This video was recorded on March 27, 2017.
Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, March 27, 2017. My name is Gaby Lapera, and joining me on Skype is John Maxfield, banking specialist. How's it going, John?
John Maxfield: It's going great! How are you doing, Gaby?
Lapera: I am doing really well. I was just telling Austin that I've had my first taste of adulthood and that I needed an antacid this morning.
Maxfield: Oh no! [laughs] Adulthood, boo.
Lapera: [laughs] I know, it's terrible. But yeah, how was your weekend?
Maxfield: It was great. I have twin five year olds, so it's like going to the zoo for two days and hanging out in the lion's den. I don't know how my wife does it.
Lapera: I'm sure they'll really appreciate this episode of Industry Focus when they're older. [laughs] I had a good weekend too. I went rock climbing. It's a lot of fun, guys. I think everyone should go rock climbing. I climbed a 40-foot wall, and I'm scared of heights, so it was a big accomplishment for me.
Maxfield: Oh, wow.
Lapera: I know, right? Talking about other people who have had big accomplishments, you did an interview with the U.S. [Bancorp] CEO, Richard Davis. Davis is actually stepping down from his position soon, but it's a really well thought-out, long-planned move, much like everything Davis has done before. But, this is a really good time to talk to him, and talk to him about how he saw his role at one of America's best banks.
Maxfield: Yeah, and if you think about it, to put Richard Davis in perspective, U.S. Bank is the fifth-largest commercial bank in the United States. Why would you dedicate a whole podcast to U.S. Bancorp? If you're in banking, you would know. But if you're not in banking, the big question is, "Why would you do that?" And the answer is twofold. First, Davis, if you just think about the greatest bankers of our generation, you have Robert Wilmers at M&T Bank, you have Jamie Dimon at JPMorgan Chase, you have a guy named William Demchak at PNC Financial, and you have Richard Davis. Richard Davis is literally one of the greatest bankers of the current generation. So, what can we learn from him? We are all investors. What can investors learn about being able to identify not only really good bankers, but also really good banks to invest in?
Lapera: Yeah. A little background on Richard Davis, Davis started at U.S. Bancorp in 2006, 10 years ago, when everything was rosy and great for the banking industry, and it turned around pretty quickly, as I think most listeners know. U.S. Bancorp sailed through the financial crisis without much of a problem. In fact, they managed to take their solidity through the financial crisis and grow and outperform a bunch of other banks, which is a very impressive thing to do, when everyone else around you is failing, for you to be like, "I'm fine, and not only am I fine, but I'm going to do great."
Maxfield: One clarification, in December of 2006 was when he was promoted to CEO. Davis has actually been with U.S. Bancorp for a little bit longer, because he was part of that original group -- there was a transformative merger in 2000 between Firststar and U.S. Bancorp that then created the U.S. Bancorp that we know today. And Richard Davis was kind of the No. 2 guy in that deal, and he finished his ascent through the ranks, and in December 2006 is when he took over. To your point, when he took over, U.S. Bancorp was already one of the most profitable banks in the country, and everything looked absolutely fantastic to them. But it was not too long after that that all dominos started tumbling in the financial crisis. Most banks, over 500 banks, failed during and after the financial crisis. And the banks that didn't fail, a lot of them got picked up for pennies on the dollar by better-positioned banks. And the banks that either didn't fail or didn't get acquired by better-positioned banks really struggled in the financial crisis, and lost a lot of money, like Bank of America and Citigroup. U.S. Bancorp was one of those few banks that didn't fail, wasn't picked up for pennies on the dollar by a competitor, didn't suffer enormous losses, and actually, to your point, emerged from the financial crisis in a stronger competitive position relative to its peers than it entered it.
Lapera: Yeah. It's really a very impressive thing. I do want to read a little bit of the Wall Street Journal article on Richard Davis stepping down as CEO, because it really tickles my funny bone. The Wall Street Journal says, "Mr. Davis says he doesn't have any specific plans for his future, but 'will never ever work for another financial institution.' He plans to do 'something so different that I don't really know what it's going to be.'" Good for Mr. Davis. [laughs]
Maxfield: And here's one of the interesting questions -- he's 59, and he's run one of the best-run banks in the country for a decade, and he's retiring at 59. The question is, why would you retire so early? And this has not been confirmed by U.S. Bank. In fact, they've actually come out and denied that this is the case. But there are credible reports that he's being considered for a position on the Federal Reserve Board of Governors. Not only is this relevant to investors, because they want to know about how to pick good banks, but it's also relevant because he could be one of the main financial policymakers în the country. And, to be perfectly honest with you, let me disclose my bias, I think he would be a fantastic person to join the Federal Reserve board.
Lapera: He also strikes me as the type of person who doesn't retire well. Shout-out to my mom, who has now retired three times, and is currently in New York working for American Express. [laughs] But, let's get into some of the things he said --
Maxfield: Let me bring up one more point, Gaby. To tease out further this idea that not only did they survive the crisis, but they thrived through the crisis -- there's this "antifragile" concept that this guy by the name of Nassim Taleb -- he's a really famous author in the financial sphere -- came up with. That whole idea is, the best kind of corporation or institution is one that actually doesn't fall apart in times of crisis or chaos, but actually gains more strength and stability during times of crisis and chaos. And that is exactly what U.S. Bancorp did. And this is really critical in banking. If you look back 150-160 years, the United States banking industry has suffered some type of crisis almost once every dozen or so years. So, if you're not strong enough to make it through those, you don't have a very bright future, because another one is going to come down the pipe. We don't know when, but another one is coming. Then, if you actually dig into the numbers of how U.S. Bancorp performed both going into the crisis and coming out of it, there's a couple really interesting things that you see. The first is, right now, it's the most profitable bank in the country, based upon return on equity, and that's your principal profitability metric in the banking industry. And it was one of the most profitable banks, I can't tell you if it was exactly the most profitable bank of 2006 or 2007, but it was among the most profitable banks if it was not the most profitable bank. But here's the thing. If you compare how much higher its profitability was relative to the average bank in the industry, that margin has doubled since the financial crisis. That's one point -- the point being, it's in a much stronger competitive position than it was before the crisis.
The second point is, if you look at the annual growth in its book value per share, which is really the thing that's going to drive the underlying value of bank stock, the rate of growth of its book value per share has accelerated after the crisis relative to before it. This is not to say that it performed as well as it did in normal times during the financial crisis, because its profitability was not as high during the financial crisis. But that's expected. Banks aren't going to make quite as much money in times like that. But, it has come out of that so much stronger.
Lapera: Yeah, and that's why we're so excited to talk about your interview with him today. He's really an underappreciated, at least among regular people, shining light in the banking industry. Let's dig into this interview. Do you want to talk metrics or constituencies first?
Maxfield: I think we should talk constituencies first. I think his point was a really valuable point, not only just for bank investors, but for investors in general.
Lapera: Yeah, definitely. One of the things that Richard Davis talked about in your interview is that there are a lot of different constituencies. In fact, he says, "Our main constituents are our customers, shareholders, employees, analysts, and the ratings agencies." It's really interesting, because he says that the most important of those constituents are the rating agencies.
Maxfield: Right. So, you have each of these constituents. So, think the CEO of such a big bank, and he's also the chairman, so there is no one above him at the bank, per se. But that doesn't mean he doesn't have constituencies that he has the answer to. The complication with those constituencies is, some of them have different objectives than other of the constituencies. So the question is: How do you balance those? And let me give you a very precise example, the analyst community. These are people, men and women who look at companies, look at their fundamental performance, look at the valuation of their stock, and try to determine and give advice to other investors on whether these companies are buy, hold, or sell. Everybody knows what analysts are. But the problem with analysts is, they are focused on what's happening right now.
Lapera: Yeah, in the short term.
Maxfield: Right. And quite frankly, you could expand that a little bit more and say that they're actually interested in what happened last quarter. Because they're outsiders, they don't have access to inside data. So, the only data they get is data that is historical. So, when U.S. Bancorp reports its quarterly reports or annual report, that's when the analysts actually get to see the data. But the ratings agencies, they're more interested in long-term stability. They're trying to say, "This is a company that bondholders can buy and not have to worry about them defaulting on their debt." And the other thing with ratings agencies that's really critical to understand about ratings agencies, both for banks and investing in any type of company is, these are insiders. A point that Richard Davis made to me on the phone was, he can basically show a person from a ratings agency anything that he would show Andy Cecere, who is going to take over as CEO in April at the meeting. So, the rating agencies, not only do they have the same long-term perspective that U.S. Bancorp does, and conservative philosophy toward banking in order to be safe and sound, but they also have the best data about U.S. Bancorp's not only current performance -- and I mean, like, today's performance -- but also its projections for revenue over the next 90 days.
Lapera: Yeah, it's definitely really interesting. I think his biggest point in here is, he has all these constituencies. Like any politician, he wants to keep them all happy, but many of them have conflicting interests. You have these ratings agencies that dictate -- and the reason the ratings agencies are so important is they dictate how good of a credit risk the bank is, so that dictates how cheaply the bank can borrow money. Which is huge. And you want to keep them extra happy. That's why, for him, they're the most important people. But then you also have these analysts that are going to say whether or not you think the bank is a buy right now, and like you said, they don't have access to all the same data that the credit agencies do. So, it's kind of this crazy dance. The bank obviously wants to outperform, and that's what the analysts are really happy with. But then, you have credit agencies and they see you outperforming, and they're like, "How are you doing that? Are you sure that's sustainable? Are you going to be a good credit risk going forward? Are you doing anything hinky to outperform?" I don't think that they say the word "hinky," that might just be me, [laughs] but you get what I'm saying.
Maxfield: Have you been taping their meetings, Gaby? [laughs] The other point is, to dig into that low debt rating -- underlying his entire idea that the rating agencies are the most important constituency is this link between your credit rating or your debt rating as an institution and the price that you can borrow money at, the interest rate that you can borrow money at. It's no different than for us. If I have a bad credit rating and you have a great credit rating, Gaby, and you and I both go to buy a house, and we both go to apply for a mortgage, you're going to get a better interest rate on your mortgage than I'm going to get. It's the same exact thing with the banks. So, why does this matter? It matters because, we've talked about this on the show before, if you think about what banks do, fundamentally, all they do is buy money for as inexpensively as they can, either by getting depositors or by going out and borrowing money from institutional investors on a short or long-term basis, and then they turn around and sell that money at a higher price by loaning it out, or buying higher-yielding government securities. The goal is to maximize that gap. If you're getting your money -- because, U.S. Bancorp has the best debt rating in the bank industry, which means it can get its money at the lowest possible rate of any of its competitors -- it means that gap is not only larger, so it's making more money, but it also gives it leeway to go out and negotiate with the best-performing, most creditworthy customers, to then bring into your loan book, which also decreases your loan losses in the future. So, you have that immediate impact of lower-cost funds, the longer-term impact of lower loan losses.
Lapera: And you have these customers, the reason these customers are so valuable, the ones that are going to decrease your loan losses because they're going to pay on time, they're also very savvy, so, they're looking for someone with low interest rates, which U.S. Bancorp can offer because they borrowed the money at such a low rate. The other thing I want to mention really quick is it's technically not a zero-sum game. There can be multiple companies with the best credit rating. But it's very difficult to attain.
Maxfield: Yeah. And another point that Davis made about the credit rating is, going into the crisis, everyone assumed the banks were safe. We went through some pretty hairy times during the 1970s and 1980s in the banking industry. But other than that, in the last eight or nine decades since the Great Depression, it's been relatively quiet. But the financial crisis made them realize and made them become much more discerning customers. So, what they use to direct which bank to go toward, in terms of bringing their deposits, is the bank's credit rating, because it's supposed to suggest whether they're safe and sound. So, what's interesting is that, to build off those things it gained in the financial crisis, in the five years after the financial crisis, 2008 to 2012, its deposits grew on an organic basis -- not through acquisitions, but just through more companies and people bringing their money to U.S. Bancorp -- by a double-digit percentage in five consecutive years. It is the only large bank that is even close to that. There are other banks that grew their deposits by double-digit percentages one or two years, but none that grew it at that rate for five consecutive years.
Lapera: Yeah. And that's part of the reason why, when you look at their valuation now, it's so much higher compared to other banks, even after the little Trump bump where you saw all banks go up 30% in a quarter. U.S. Bancorp is still rated among investors as one of the most sought-after banks, one of the most valuable banks. Which brings us to the third set of stakeholders. You have these analysts who want these short-term results, you have these credit agencies who are really worried about long-term functioning, and in the third camp grouped with the credit agencies but operating in a different level in terms of the bank are the investors, who also want to see long-term results, but who are also interested in the short-term results. It's this balance that he has to keep everyone happy.
Maxfield: But here's the interesting thing about U.S. Bancorp shareholders. Shareholders are not all the same. You have some shareholders that are day traders, you have some shareholders that are long-term investors, you have some that are value long-term investors, you have some that are growth long-term investors. The particular type of investor that U.S. Bancorp gets just so happens to be very similar to the type of investors that Warren Buffett gets. In fact, Warren Buffett's company, Berkshire Hathaway, is one of U.S. Bancorp's largest shareholders. These investors are value-oriented on a long-term basis, they're looking for long-term growth. You have a really convenient alignment for U.S. Bancorp between both its own conservative operating philosophy, the perspective of its long-term shareholders, and the perspective of ratings agencies. You put all those things together in U.S. Bancorp and you add it with its performance metrics, and right now it's in an almost unassailable competitive position.
Lapera: Definitely. I'm just going to move us along, because we're starting to run out of time. Let's talk about efficiency ratios. What is an efficiency ratio? Very easy question for you.
Maxfield: Efficiency ratio, this just measures the percentage of revenue that a bank spends on operating expenses.
Lapera: Yes. So, the lower the efficiency ratio, the better. Most banks shoot for an efficiency ratio of around 60%. Drumroll. I don't think you can hear that. [laughs]
Maxfield: It's a very quiet drum. [laughs]
Lapera: What is U.S. Bancorp's efficiency ratio?
Maxfield: U.S. Bancorp's efficiency ratio last year, its GAAP efficiency ratio, which is just taking your non-interest expenses, so, your operating expenses divided by net revenue, was 55%.
Lapera: That's really good, for people who don't know. Amongst the other top big banks, you have Bank of America sitting at 66%, Wells Fargo and Citi both around 59%, JPMorgan around 58%, and those are the big banks. In general, they operate pretty well. Below the eighth-largest bank, most banks' efficiency ratios are pretty above 60%. There is an exception. I think New York Community Bancorp (NYSE:NYCB) might be the country's 25th biggest bank, but it's doing this thing where it's been sitting around $48.9 billion in assets so it doesn't trip the regulatory threshold for having more regulations put on it. And its efficiency ratio is abnormally low at 44.5%. It's a really interesting bank because of the niche that it lives in, it lends primarily to people in New York City, to people who are looking for multifamily residences -- read that as apartment buildings. New York City is a great place to do that because of rent control. You know that your building is always going to be full of tenants, and you know those tenants are going to pay on time because they're living in some of the cheapest apartments in the city, and that means landlords always make their payments. And since New York Community Bancorp is operating in this very special environment, its costs are much lower, and its income is much more reliable than other banks, hence the very low efficiency ratio. Barring that, 55% is incredible.
Maxfield: Yeah, 55%, it's incredible, because U.S. Bancorp is more of a general-purpose bank. But I'm glad you brought up a New York Community Bancorp, because it illustrates a really important point. Let me pull up a little bit and give a broader perspective, and then we'll dig in a little bit more. I think it was in his 1990 shareholder letter, or 1991, where Warren Buffett -- and, I talk about Warren Buffett a lot in terms of banking because he really understands banking, perhaps more than anybody, but those great bankers I listed at the beginning of the show, Warren Buffett understands it more. He says, "If you want to outperform in an industry that is highly commoditized, like banking is, two things have to be the case. Either one, you have to have a niche product and earn outsized margins because you have expertise in that particular area that nobody else has; or, you have to be the low-cost producer. That New York Community Bancorp, it's in that niche area, and that's why it's been able to outperform the industry so much over the last few decades. Here's what's so interesting about what Richard Davis has to say about the efficiency ratio and how that plays into how Warren Buffett sees banking. Richard Davis says, "You don't drive efficiency through lowering expenses. You drive efficiency through increasing your revenue." There's a great quote, let me pull that up. He says, "He who has the lowest efficiency ratio also often has the biggest revenue, which is in the denominator." And this is true. If you look at, not the efficiency ratio, but if you actually look at expenses as a percentage of assets, U.S. Bancorp's expenses as a percentage of assets is actually higher than a lot of these other big banks. But its revenue as a percentage of assets is much, much higher on a relative basis, relative to its expenses. That's why its efficiency ratio is so low. So then you say, "Look, how do you get your efficiency ratio so low?" And the answer to that, in U.S. Bancorp's case, is twofold. Number one, and this ties back into Buffett's point, Richard Davis says, "You have to go after businesses where," let me give you exactly what he said. "A bank needs to look at what it does and get into businesses where it can, one, be better than everyone else, two, where it has skills that no one else has, or three, where it can outperform its own history." He's basically saying, "Look, Warren Buffett's paradigm," and I don't think he meant to say like this, but this is how I look at it, "Warren Buffett's paradigm where if you want to outperform, you either have to be a niche operator or the low-cost operator, those two things are not mutually exclusive. In fact, you can be a low-cost operator by running it through a niche operation, because that will jack up your revenue and make your efficiency ratio go down."
Lapera: Yeah. I think the point he's driving at is, it's OK to spend money on expenses, too, because that means your underwriting quality is really strong, and that helps drive higher revenue.
Maxfield: And another point he makes is, you can't be dogmatic about these types of things. Because the banking industry is in such a tough revenue environment because interest rates are so low, the question is, do you then starve innovation and investment and stuff like that just in order to get a couple basis points here or there on your efficiency ratio? Or do you continue to invest? One of the things he says is, "When we think about efficiency, we run it through this idea of return on investment. We're not going to starve off expenses just for the sake of starving off expenses. What we're going to do is, if you want to go out and spend money," this is, like, Richard Davis talking to his folks, "that's fine, but you have to have the numbers that the returns are going to be there." So, what they do is, these people who have these ideas, they go in front of these committees that determine if they want to make these investments. But again, it all goes back to this idea that, if you want a really low efficiency ratio, running it through the expense side may actually not be the most effective. You want to run it through your revenue side. You can do that by thinking about making sure that you're making always very good, profitable investments.
Lapera: Yes. I actually want to get into some words you said earlier, which is, the importance of being flexible and non-dogmatic. That's kind of a recurring theme in the interview you had with him, and it's related to everything to do with from the financial crisis to whether or not investors should buy at certain times.
Maxfield: Yeah. What I think about that non-dogmatic thing, -- and I've talked about this before on this show in the past -- I think about Phil Tetlock's book, Superforecaster, Tetlock is this guy who's an expert, one of the world's leading experts, if not the world's leading expert, on forecasting. He looks at, there are certain people who are better forecasters than others. And he digs into what qualities they evidence that make them able to be such good forecasters. One of them is that they eschew dogma. In the banking industry -- that's basically the exact same thing that Richard Davis is saying. And one of the examples he gives is, in one of the recent quarters, they increased their loan loss provisions, and they were one of the only big banks, if not the only big bank, to actually increase loan loss provisions last quarter.
Lapera: Which, I'm guessing, made analysts freak out, because they're like, "What's wrong with the bank?"
Maxfield: Yeah, that's exactly right! Analysts were like, "Whoa, are you hiding something in your portfolio?" And he was saying, "Look, banks are still growing their loan portfolios right now. When you're growing your loan portfolio, the responsible thing to do is to increase your provisions, because even the best-run banks, once in a while, experience loan losses, and you want to provision ahead of that to be prepared for those loan losses." And he's saying, "We're just doing the responsible thing. You want to prepare for crises ahead of them, as opposed to waiting until they actually strike." But again, that goes back to that point that analysts, because provisions act on your income in the same way that expenses do, analysts don't want to see those provisions go up. So, they're thinking, again, about either right now, the short term, or, looking in hindsight, whereas Richard Davis, and other great bankers and investors and business people are constantly looking forward.
Lapera: Right. And the dogma in this case that he's ignoring is the analysts' idea that if your bank is growing really quickly, that's great, and you should just continue putting more resources into growing loans as opposed to putting resources into protecting yourself from potential future failure. That's the thing, that's what he's trying to get at when he says, "Don't be dogmatic, don't just stick to what everyone thinks you should do. You should do what you think is right."
Maxfield: That's right. And let me expand on that point you made, because I think I answered a different question than you asked me. In the investment space, where that dogma comes into play -- at The Motley Fool, we're really against market timing, because there are studies that show if you're a day trader or someone who is exclusively focused on timing the markets, you're going to underperform the markets. You may as well dollar-cost average into a low-cost exchange-traded fund that tracks the broader market. That's the best way to do it, if you think you're going to scoot in and out. That's the general rule -- you don't want to turn the market. However, there are exceptions to that. If stocks are indisputably really high, if you think they are, you might want to tailor back the rate of your investments at that time period, and wait until correction, because historically, corrections happen once a year. A correction is, if something drops 10% or more in the market. As a general rule, again, dogmatically, you want to avoid timing the market. However, there are exceptions, because you also want to be aware of where the market is at in one particular time, because you may want to change the rate of your investment, depending on where the market is at.
Lapera: Yeah, absolutely. There's definitely a lot more interesting stuff that we can talk about in this interview, but I know that you're actually writing an article or two about this, right?
Maxfield: I am, yeah, there's going to be a few things coming out here pretty soon. Stay tuned. It's a good article, it's coming together really great.
Lapera: Yeah. And if you guys want that article, definitely email us at email@example.com, or by tweeting us at MFIndustryFocus. But if you email us, I will definitely respond a lot faster, because I don't really know how to use the Twitter, despite being a young person. Although, maybe not, I had to use an antacid this morning, so who knows? As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks so much for joining us, John! Thank you to Richard Davis, if you happen to listen to our humble podcast, for letting John interview you. And, thanks to the listeners for letting us natter on for so long. Happy birthday to my favorite producer, Austin Morgan. Austin, how old are you?
Austin Morgan: The ripe old age of 26.
Lapera: Oh my god.
Maxfield: Oh, you are a spring chicken, Austin.
Lapera: [laughs] I hope you have a great birthday. Thanks to everyone for listening, and I hope everyone has a great week!
Gaby Lapera owns shares of JPMorgan Chase. John Maxfield owns shares of Bank of America, US Bancorp, and Wells Fargo. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends American Express. The Motley Fool has a disclosure policy.