Want to know why US Bancorp (NYSE:USB) was the most profitable bank in America last year? A good place to start is the fact that it doesn't provide free coffee to its employees.
That may sound harsh and inconsequential, but it reflects a fundamental reason that US Bancorp is all but impossible for its competitors to beat. Namely, it has one of the lowest cost structures of any bank in the industry.
The Minneapolis-based company spent only 53.2% of its revenue on operating expenses in the second quarter of this year. By contrast, the average bank in the United States spends more than 60%, according to the most recent FDIC data.
The significance of this measure, known as the efficiency ratio, can't be overstated. In the first case, it illustrates how much of a bank's revenue is left over to set aside for future loan losses, pay taxes, distribute to shareholders via dividends or share buybacks, and to build a bank's book value per share.
Just as importantly, it also seems to spill over onto a bank's underwriting discipline, as banks with low efficiency ratios tend to charge off fewer loans. This presumably follows from the fact that investors expect banks to, within reason, maximize their return on equity, calculated by dividing a bank's net income by its shareholders equity.
To be competitive, a bank with a bloated expense base must make up for the deficit elsewhere. And the easiest way to do so is to underwrite riskier but higher yielding loans. This boosts a bank's net interest income in the short run, but exposes it to elevated losses when the credit cycle inevitably turns.
Columbia Professor Charles Calomiris alludes to this in Fragile by Design: "Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind."
Warren Buffett, the most successful bank stock investor of all time, has similarly identified efficiency as one of only two ways that a company in a commoditized and highly competitive industry like banking can outperform its peers as well as the broader market.
As Buffett wrote in his 1987 letter to shareholders:
The insurance industry [which, for our purposes, is indistinguishable from the bank 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.
That US Bancorp has chosen such a hard line on expenses -- how much difference does free coffee actually make to a $410 billion bank? -- will come as no surprise to people who have watched it evolve over the years.
Its current CEO, Richard Davis, formerly worked under Jerry Grundhofer, who, in turn, worked at Wells Fargo (NYSE:WFC) under Carl Reichardt, arguably the best big bank CEO since World War II -- the other contender is Walter Wriston, who led Citicorp (now Citigroup) from 1967 to 1984.
It was Reichardt who instilled the "Wells way," a method of operating that consists of robust revenue growth and expense control counterbalanced by equally aggressive risk management.
As Bank Director magazine's Jack Milligan wrote in 2000:
Grundhofer, like his 61-year-old brother, rose through the ranks of Wells Fargo bank in California. Both took to heart the 1980s-era cost management principles instilled by former Wells chief executive Carl Reichardt. Jerry would later adapt what became known as the "Wells way" -- an intense focus on efficiency balanced by strategic investments and generous employee incentives -- into what might be terms a "Firstar way."
(The US Bancorp we know today came from Minneapolis-based Firstar's 2001 acquisition of Oregon-based US Bancorp.)
The takeaway for investors is this: If you're looking for a great bank stock, your objective should be to find one that, like US Bancorp, understands and appreciates the connection between free coffee and outstanding shareholder returns.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of 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.