Finding the best bank stocks for your portfolio seems hard, but it really isn't. There are only a handful of variables that you need to factor into your analysis.
A quick digression
Before delving into the details, it's important to keep in mind that a bank is like any other business. To make a profit, even the biggest and most complex lenders must maximize revenue and minimize expenses. To learn more about the banking industry, click here.
"Banking is a bit like running a small retail store," JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon explains. "You gotta work out what kind of stuff your customers want. Then you gotta get the stock in, and sell it as quickly as you can, making a profit."
The one complication is that sometimes the objective to maximize revenue can backfire. This happens when a bank's strategy to boost its top line consists of reducing lending standards and making loans of dubious credit quality. It was this very behavior in fact that caused the financial crisis.
The three most important variables
With this in mind, there are three variables you should consider when searching for the best bank stocks for your portfolio. The first, as I've already intimated, is revenue. And, more specifically, it's preferable to look at revenue as a percent of assets, as this allows you to compare banks irrespective of size.
The second variable captures expenses. The best measure of this is the efficiency ratio, which divides operating costs by revenue net of interest expense. As I've explained elsewhere, a lower efficiency ratio is ideal, as it means that a larger proportion of revenue flows through to the bottom line.
And the third variable relates to loan losses. Known as the nonperforming loan ratio, it measures the percent of loans that are either in or on the cusp of default. Again, like the efficiency ratio, a lower NPL ratio is preferable to a higher one.
As a final note, it's critical to look beyond the current metrics to see how well a bank performed through a full credit cycle -- which, at present, can be captured by an average of the decade from 2004 through 2013.
The three best bank stocks for your portfolio
Taking all of this into consideration, there are three banks that have separated themselves from the pack over the past 10 years. And as an added vote of confidence, all three of these banks have found their way into Warren Buffett's portfolio at Berkshire Hathaway (NYSE:BRK-A).
They are Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB), and M&T Bank (NYSE:MTB). As you can see in the preceding table, all three of these banks perform at or near the top of their peer group in at least two out of the three variables.
It's no coincidence, in turn, that these are among the best-performing bank stocks over the past 30 years, generating compound annual growth rates of 12.5%, 12.9%, and 15.8%, respectively, between 1983 and 2013.
The takeaway here is this: If you're going to add a bank stock to your portfolio, it'd behoove you to only consider the best. And when picking the best, these three lenders, as well as the three-part analysis outlined here, are a great place to start.