Successful investing means identifying companies with durable competitive advantages that allow them to generate wider margins than their peers and the broader market. In the context of banking, this principally boils down to size and efficiency.
How successful banks differentiate themselves
Banking is a competitive industry that, for the most part, sells a commodity -- money. In such an industry, "only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels," says Warren Buffett.
The data more than backs up Buffett's assessment. Over the last few decades, the best-performing bank stocks have consistently spent a much smaller percentage of their net revenue on operating expenses than their less successful peers.
Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) provide two cases in point. Both banks are among the most efficient large lenders in the country, with efficiency ratios consistently below 60%. They've also generated some of the industry's best shareholder returns dating back over three decades.
Another textbook example is New York Community Bancorp (NYSE:NYCB). Since going public in the mid-1990s, the New York City-based bank has returned a total of 3,720%, or nearly twice that of even U.S. Bancorp -- which, in my opinion, is the nation's best-run big bank. New York Community Bancorp has done so by spending less than half its net revenue on expenses, and returning the remainder to shareholders by way of generous quarterly distributions.
How size factors into the equation
It's important to keep in mind that size plays a central role in an individual bank's efficiency -- all three of the banks above are among the nation's largest. According to the FDIC, the average bank with more than $10 billion in assets on its balance sheet spends 62.4% of its net revenue on operating expenses versus an average of 80.4% for banks with less than $100 million in assets.
Beyond economies of scale, one of the reasons size matters is that it's a proxy for diversification, which helps to insulate a bank from regional and industry-specific downturns. JPMorgan Chase (NYSE:JPM) chairman and CEO Jamie Dimon made this point in his latest letter to shareholders:
Many large banks had no problem navigating the financial crisis, while many smaller banks went bankrupt. Many of these smaller banks went bankrupt because they were undiversified, meaning that most of their lending took place in a specific geography. A good example was when oil collapsed in the late 1980s. Texas banks went bankrupt because of their direct exposure to oil companies and also because of their exposure to real estate whose value depended largely on the success of the oil business.
But size isn't a panacea. Bank of America (NYSE:BAC) and Citigroup (NYSE:C) are the nation's second- and third-largest banks by assets, but they're also two of the least efficient. And both have left long-term investors in the lurch. Over the past decade, Bank of America's stock price has dropped by 64%, and Citigroup's is off by 88%. Meanwhile, the S&P 500 has climbed by 82%.
Thus, while size is a seemingly necessary element of a bank's long-term success, size alone isn't sufficient; a bank's managers must also bring a disciplined approach to the statistically correlated concepts of risk and expense management.
It's at this intersection that the competitive advantage of the best bank stocks lies. In short, if you're looking for a bank stock with a legitimate chance of beating the market in the years and decades to come, than your objective should be to find the biggest and most efficient bank available at the lowest possible price.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc, JPMorgan Chase, and Wells Fargo. 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.