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"The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels." -- Warren Buffett
It's fair to say that Warren Buffett completely transformed the way I think about banking -- or, more specifically, about how I believe investors can distinguish between banks that are likely to outperform their peers and the broader market versus ones that aren't. It all boils down to the relationship between the leanness of a bank's operations and the durability of its competitive advantage.
If you read between the lines of Buffett's shareholder letters, he breaks the world of companies down into two categories.
On one hand are companies that operate in industries with favorable economic characteristics. The patent protection that allows pharmaceutical companies to generate wide profit margins comes to mind. Any type of monopoly, be it a leading local newspaper or a utility company, also qualifies. And industries in which a business can readily distinguish its products or services from its competitors fits the bill as well.
Coca-Cola and Procter & Gamble serve as cases in point. Because consumers know and trust these brands, Coca-Cola and Procter & Gamble can demand a much higher price for their products than generic counterparts can. This allows these companies to earn more money, reinvest their retained earnings more profitably, and generate greater returns on investment for their shareholders relative to those of their competitors with less brand power.
On the other hand are companies that operate in industries with, to use Buffett's wording, "dismal economic characteristics that make for a poor long-term outlook." What the 84-year-old billionaire is referring to are companies that sell commodity-like products or services. In this situation, the biggest differentiating factor between one company's offerings and another's is the price.
While Buffett's quote relates to the insurance industry -- which is cursed by "hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way" -- the distinction applies with equal force to banks. This is because banks sell the most commoditized product of them all: money. If one bank makes loans at a lower interest rates (i.e., price) than a competing bank, it follows that borrowers will flock to the former at the expense of the latter.
But this presents a conundrum. If banks mainly sell a commoditized product, then how is it possible that certain lenders consistently outperform not only their peers, but also the broader market? And along these same lines, if insurance companies and banks face such "dismal economic characteristics," then why would Buffett organize his business around them? After all, Berkshire Hathaway, at its core, is an insurance conglomerate holding tens of billions of dollars' worth of bank stocks in its securities portfolio.
The answer to this question lies in the realization that well-run banks and insurance companies can acquire a durable competitive advantage even though they sell a commodity. "In such a commodity-like business," Buffett explains, "only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels."
The power of this insight, particularly as it relates to low-cost operators, can't be overstated. As I've demonstrated before, there is a tight correlation between a bank's return on assets -- the industry's leading profitability metric -- and its efficiency ratio, which measures the percentage of a bank's net revenue absorbed by operating expenses. Holding all else equal, it's reasonable to assume that a bank with a lower historical efficiency ratio will be more profitable in the future than a bank with a higher efficiency ratio.
It's this simple realization, in turn, that transformed how I think about banking. Now, when I leaf through a bank's financial statements, one of the first things I look at is its efficiency ratio -- and, ideally, how its ratio has trended over an extended period of time. I would even go so far as to say that, thanks to Buffett's insight coupled with my analysis of the data, this has become my primary litmus test for identifying lenders that are worthy of investors' hard-earned money versus those that aren't.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway, Coca-Cola, and Procter & Gamble. The Motley Fool owns shares of Berkshire Hathaway and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. 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.