What is the best big bank in the country?
The McLean, Virginia-based regional bank turned in a solid performance virtually across the board, scoring sixth place or higher in four out of the five metrics used by the publisher to rank U.S. banks with at least $50 billion in assets on their balance sheets.
Little Rock, Arkansas-based Bank of the Ozarks (NASDAQ:OZK) led the way for banks with between $5 billion and $50 billion in assets. Los Angeles, California's Preferred Bank (NASDAQ:PFBC) came in first among lenders with between $1 billion and $5 billion in assets.
"If there's one thing that all three winners of the 2015 Bank Performance Scorecard have in common, it's a carefully focused strategy that is the polar opposite of the plain vanilla business models that most banks pursue," wrote Bank Director's Jack Milligan, one of the nation's most knowledgeable bank commentators.
Capital One did particularly well where it mattered most, placing second and fifth among similarly sized banks in return on average assets (1.53%) and return on average equity (10.33%).
These are the two primary metrics used by analysts to gauge bank profitability. While higher numbers are generally better -- assuming they aren't inflated by imprudent underwriting -- the minimum threshold to be a top-shelf lender is a return on average assets of 1% and a return on average equity of 10%.
Roughly speaking, these benchmarks correspond to a bank's cost of capital. If a bank exceeds them, it's creating value for its shareholders. But if it comes up short, then it's theoretically destroying value after you consider the lost opportunity cost of not investing in a risk-free investment alternative.
Bank of the Ozarks' performance was even more impressive than Capital One's in this regard. The $6.8 billion lender led by CEO George Gleason earned a surprisingly high 2.13% on its average assets and 15.97% on its average equity last year, placing it second and third in the respective categories.
Preferred Bank's results were more closely aligned with Capital One's, reporting profitability ratios of 1.31% and 10.98%.
Also factoring into Bank Director's ranking was the relative size of each bank's capital cushions. It's worth keeping in mind that banks are little more than highly leveraged investment firms that use federally insured deposits to make loans and buy fixed-income securities.
As such, regulators require banks to retain a certain amount of capital that can be used to absorb future loan losses. This is what the tangible common equity ratio measures, with a higher figure corresponding to a larger capital cushion.
It should come as no surprise that each of these three banks reported year-end capital ratios well in excess of regulatory minimums. Capital One ended the year with a tangible common equity ratio of 9.82%. Bank of the Ozarks finished at 12.05%. And Preferred Bank closed out 2014 with a ratio of 11.44%.
The final two metrics analyzed by Bank Director gauge asset quality, reflecting the percent of a bank's loans that have been charged off or are on the verge of default. These are important measures, but at this stage in the cycle they're on the descent for the majority of lenders. Consequently, as Rafferty Capital Markets Richard Bove observed last month, they're of secondary concern right now to interest rates and earnings.
Consistent with this sentiment, Bank Director gave the two asset quality metrics only half weightings. "The Scorecard rewards banks that are well balanced across the full spectrum of profitability, capitalization and asset quality -- but with a slight bias toward profitability," Milligan wrote.
This bias worked in the winners' favor, as all of them ranked outside the top 10 in one or both asset quality measures. In at least Capital One's case this is to be expected, as credit card loans are riskier than other types of lending products -- the corresponding reward is a higher yield on earning assets that pads Capital One's profits.
If an investor were looking for a unifying theme, I agree with Milligan that it revolves around the ability of these banks -- Capital One and Preferred Bank in particular -- to leverage the advantages of their market niches. Capital One is the nation's only monoline credit card company to evolve into a full-fledged regional bank, while Preferred Bank focuses on business borrowers in and around the Los Angeles metropolitan area.
John Maxfield has written for Bank Director magazine in the past and has an article pending publication in its upcoming digital edition. John has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.