Few companies have attracted as much ire over the last decade as Wall Street banks, but this doesn't necessarily mean they're all bad investments. What follows is a look at the best stocks for investing in Wall Street banks.
Wall Street banks defined
Wall Street banks aren't like you typical banks. That isn't because they're located on Wall Street -- none of them actually are -- but rather because of what they do. While most banks spend their time attracting deposits and originating loans, Wall Street banks engage in a variety of other activities in addition to these:
- They offer advice to corporations about mergers and acquisitions.
- They manage people's wealth.
- They underwrite debt and equity securities.
- Most operate retail and prime brokerages -- the former are geared toward individual investors, while the latter are for institutional investors such as hedge funds and insurance companies.
- Many have large trading operations that profit from buying and selling financial securities.
In the wake of the Great Depression, policymakers blamed the intermarriage of commercial and investment banking for fueling the unprecedented depth and duration of that once-in-a-century crisis. As a result, firms such as J.P. Morgan were forced to separate their investment banks from their commercial banks -- in J.P. Morgan's case, it split into Morgan Stanley and what is now JPMorgan Chase.
But after seven decades, Congress repealed that prohibition in 1999. Since then, JPMorgan has jumped back into so-called "universal lending," as have Bank of America and Citigroup, among others.
JPMorgan, the nation's largest bank by assets, now generates only 44% of its net revenue from interest rate arbitrage -- that is, from the traditional banking activity of investing low-yielding deposits into high-yielding assets. The rest come from fee-based sources, such as asset management and investment banking. The following chart breaks down the share of JPMorgan's net revenue that comes from its four operating divisions.
Good versus bad Wall Street banks
Given the complexity of Wall Street banks, you'd be excused for wanting to avoid them. And you wouldn't be alone. In his book On the Brink, former U.S. Treasury Secretary and Goldman Sachs CEO Henry Paulson -- as well-versed in finance as anyone else around -- expressed doubt that the nation's largest universal lenders could effectively manage their sprawling empires:
Just as many people shop at Wal-Mart while mourning the disappearance of their local retailers, so, too, will they find their way to bigger commercial banks offering a wide range of lower-cost services and products than smaller banks do. The institutions that are emerging to satisfy all of these needs are complex, difficult to manage and regulate, and pose real risks that must be confronted.
But this shouldn't be taken to mean that all Wall Street banks -- or, more accurately, universal banks -- make bad investments. Poorly managed ones like Bank of America and Citigroup do. But well-run universal banks -- such as JPMorgan and, since its 2008 acquisition of Wachovia (which ventured into investment banking in the preceding decade), Wells Fargo -- have long been beacons of success in an otherwise disappointing industry.
Wells Fargo has been one of the best-performing bank stocks for over three decades, and as the following chart shows, both of these banks have profit margins that exceed the biggest and best-known companies in a variety of other industries.
Even though Wall Street banks are big, complex, and prone to problems stemming from these realities, the right ones -- namely, JPMorgan and Wells Fargo -- can nevertheless make profitable long-term investments.