In 2007, First Republic Bank (NYSE:FRC) was bought and merged with Bank of America (NYSE:BAC). That marriage lasted about three years until B of A agreed to divest the San Francisco-based regional bank in a management-led and private-equity-backed buyout. First Republic did an IPO soon after, returning to the public markets.
For investors, Bank of America's decision to part ways with First Republic was like throwing away a block of solid gold. Since First Republic returned to the New York Stock Exchange in late 2010, the stock has walloped B of A's stock by more than nine times.
The reason is fundamental
While Bank of America has floundered with fines, regulatory snafus, and disappointing earnings, First Republic has put the pedal to the metal. Consider the results posted by the two banks last Thursday for the fourth quarter and full year of 2014.
Bank of America saw revenues fall, and came up short of consensus earnings expectations. The bank continues to struggle with problem assets from the financial crisis, as well as lingering questions about management's ability to achieve its modest 1% return on assets goal.
First Republic's quarter could not have been any different. The fundamentals are so strong, it's easier to describe with bullets points rather than cramming all the successes into one paragraph.
- Revenue increased 17% for the year
- Core net income (as defined by the bank) set an all-time record for the bank at $453 million
- Loan originations were the second highest in the bank's history
- Book value per share increased 14.2%, year over year
- Deposits grew 15.7%
- Wealth management assets and revenue increased 28% and 29%, respectively
I could keep going. The bank turned in a monster year. Most impressive, though, is that the bank's non-performing loans represent just 0.10% of total assets. That is ridiculous.
The market reacted exactly as you'd expect, sending Bank of America tumbling more than 5% on the day. First Republic was essentially flat on a day when virtually the entire banking sector was down 100 basis points or more.
Comparing these banks is apples and oranges, but that's not the point
To be fair to Bank of America fans -- if there is such a thing -- comparing First Republic to B of A isn't exactly apples to apples. Bank of America is a massive mega bank with a very different business model than the $48 billion asset First Republic.
However, as an investor and bank stock analyst, I don't care if this comparison is apples to oranges. I just care about the phenomenal business First Republic has built, and I'm thankful that B of A divested the business so investors can once again buy shares of First Republic.
First Republic has all the characteristics of a high-performing bank stock today, and in my opinion, it has the characteristics of a bank that will maintain that performance into the future.
The bank makes its money making mortgages and business loans to, and accepting deposits from, a high-net-worth customer base in a few U.S. urban markets. It supplements its lending income with wealth management and trust businesses, two simple and complimentary businesses that are genuine value adds for their clients.
The bank puts credit and risk culture first. It proudly boasts some of the highest and strictest credit standards of any lender out there; the bank's weighted average loan to value for a mortgage is about 60%. For most banks, that number is 80% or higher. The median net worth of First Republic clients is $2.5 million, and median credit scores are 774. That's incredible.
These individuals are the customers that every bank dreams of. The difference is that First Republic actually wins the business and puts up the results. It is because of this top-tier client base that First Republic has experienced a loan-loss rate of just 0.08% on the mortgage loans originated since 1985. That is 29 years!!
For comparison, the banking industry has averaged a quarterly charge-off rate 11.75 times higher than First Republic's during the same period, using historical data from the FDIC's Quarterly Banking Profile.
You get what you pay for
First Republic currently trades at about 1.7 times book value, which is slightly expensive by bank-stock standards. As a rule of thumb, a bank stock is considered cheap if it trades below one times its book value, and it is considered expensive if it trades higher than two times its book value.
In the world of bank stocks, it pays to invest in only the very best banks. When the credit cycle turns and the economy once again goes through a recessionary period, the best bank stocks will hold up to those headwinds while other banks are toppled by loan losses -- like Bank of America, for example.
In my opinion, First Republic is one of those banks that deserves a premium. When you buy quality, you get what you pay for. And in this case, what you get is one of the best banks in the U.S.