Over the last few years, I've spent a lot of time thinking about how to identify and buy the best bank stocks. And after dedicating countless hours to studying data and researching the history of the banking industry, I've come to the conclusion that not only is it possible to single out great bank stocks, but also that it's a relatively straightforward process.

This may go without saying, but it's important to keep in mind that the objective isn't to find the best bank stock per se; it's rather to identify the best-run banks. This is because, over the long run, the most profitable lenders will generate the highest shareholder returns.

Two necessary traits of well-run banks
As a general rule, there are two traits of a well-run bank. The first, as I've discussed at length in the past, is that the most profitable banks are also the most effective at minimizing loan losses.

This isn't a coincidence. "When you think about what, in fact, distinguishes a bank as a lender," New York Community Bancorp CEO Joseph Ficalora explains, "it's how much money it loses on the asset that it chooses to take risk with."

You can see this in the chart below, which plots the relationship between loan losses and return on assets at the nation's 16 largest traditional lenders over the last decade -- this excludes stand-alone investment banks like Goldman Sachs and custodial banks such as State Street and The Bank of New York Mellon.


On one end of the cluster is Regions Financial, which had a nonperforming loan ratio of 1.9% over the 10-year period and returned only 0.2% on its assets. On the other end is U.S. Bancorp, which had the lowest nonperforming loan ratio of the bunch (1%) as well as the highest return on assets (1.6%).

This brings us to the second trait of a well-run bank: the efficiency ratio. As its name suggests, this measures how efficiently a bank is run. It's calculated by dividing a bank's operating expenses by total revenue net of interest expense -- for a list of the five most efficient banks, click here.


A simple interpretation of this metric is that it illustrates how much it costs a bank to produce $1 in revenue. For example, a ratio of 80 implies that it costs a bank $0.80 to generate $1 in revenue. This leaves only $0.20 per dollar of revenue to pay taxes and pass on to shareholders by way of dividends, buybacks, or book value appreciation.

Holding all else equal, in turn, banks with lower efficiency ratios are preferable to ones with higher ratios.

Additionally, and this is a critical insight, banks with lower efficiency ratios also tend to underwrite better loans and thus minimize loan losses. You can see this in the figure below, which compares the 16 biggest banks' nonperforming loan ratios to their efficiency ratios over the last 10 years.


The obvious correlation follows from the fact that a bank's objective to maximize return on equity. If this objective is hindered by low efficiency, then the slack must be made up through other means. And the easiest way to do so is to write higher-yielding, and thus riskier, loans.

Discussing this point in relation to the financial crisis, Columbia business school professor Charles Calomiris explained in 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."

Tying it all together
What's great about this chain of correlation is how much it simplifies the process of identifying great banks, and thereby allowing one to buy bank stocks with the best chance of outperforming the industry. In short, because profitability is correlated to loan losses, which are correlated to efficiency, then the first thing you should screen for in your hunt to buy the best bank stocks is the efficiency ratio.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.