When I think of the best-of-breed bank stocks, there are three that come to mind: US Bancorp (NYSE:USB), Wells Fargo (NYSE:WFC), and M&T Bank (NYSE:MTB). If you're going to invest in the sector, then these are the place to start.
The perils of bank stocks
It's important to keep in mind that investing in banks isn't like investing in most other sectors. I say that because banks are incredibly fragile institutions, as most lenders are leveraged by a factor of 10-to-1, if not more. Thus, all it takes for the typical bank to be rendered completely insolvent is a mere 10% drop in the value of its assets.
Moreover, a bank doesn't even have to be insolvent to fail. A mere rumor that a bank is having problems can cause its depositors to withdraw their money en masse, leaving a firm with no way to fund its portfolio of loans and fixed-income securities. This situation is known as a liquidity crisis and is the proximate cause of most banks' downfalls.
If you look back in time, you'll see that this happens on an irregular but not infrequent basis. Since the Civil War, when the era of modern banking began, over 17,300 banks have failed in the United States, equating to an average of 116 per year.
3 qualities of great banks
Now that the bad news is out of the way, here's the good news: Even though banks are incredibly risky and complicated businesses, picking a good one isn't as hard as it may seem. In my opinion, in fact, there are three things in particular that an investor really needs to look at to determine whether a specific bank will translate into a profitable investment.
The first is the diversification of its business -- both in terms of geography and product lines. In the 1980s, for instance, nearly every big bank in Texas failed after oil prices plummeted and sent real estate values in the state careening lower as well. It's for this reason that former Wells Fargo Chairman and CEO Richard Kovacevich once said:
Banks fail [because of] concentrated risk. Risk has little to do with the size of the bank. ... In fact, more small banks fail than big banks because they are generally more concentrated geographically, by product and by industry.
The second quality of a best-of-breed bank is efficiency. While banks are unique businesses, they are still businesses. As such, it's incredibly important for a bank to keep its costs down. Not only does this mean that more revenue is available to distribute to shareholders and grow book value, but, as I've discussed at length in the past and as you can see in the chart below, efficient banks also have a tendency to underwrite better loans.
Last but not least, an investor in a bank stock must get a sense for the culture and credit discipline of a bank before investing in it. "Banks fail for one reason," a well-known bank investor once noted; "they write bad loans." While this is a function of efficiency, a bank's culture of subordinating its risk managers at the expense of its revenue generators also plays a central role. To determine whether a specific bank is guilty of this, all one needs to do is to look at how well its loan portfolio held up in the latest crisis.
Thus, to circle back around to the three banks identified at the outset, all of these institutions not only run incredibly efficient operations, with efficiency ratios consistently below 60%, but they are also all widely diversified and have long histories of prudent risk management. Add it all together, and there should be little surprise that all three of them have been among the best performing bank stocks going back three decades.