Banking ought to be a straightforward, profitable business: Take in deposits and lend money out at a rate that exceeds your cost of funding. However, bankers appear to be predisposed to complicating that formula and abdicating their common sense during boom periods. That behavior isn't limited to bankers, but as the financial crisis demonstrated, it's a recipe for disaster when you combine it with gobs of leverage.
Still, not all banks are made equal in that regard; we asked our analysts to select three banks built to stand the test of time:
Alex Dumortier (Wells Fargo): There are two things a bank must do in order to stand the test of time: Make loans that are, in aggregate, profitable and avoid what I call "iceberg" loan losses that can tear a gaping hole in the hull of its balance sheet as the bank attempts to navigate its way through a deep recession or a banking crisis (which seem to be a periodic feature of capitalist economies that is unlikely to disappear).
The ability to do both is related to a single quality: Lending discipline. A bank's lending discipline, in turn, is largely a function of its lending culture. The tone for a bank's lending culture is set at the top of the organization and needs to be nurtured over time.
Among the Big Four (B of A, Citi, JPMorgan Chase, and Wells Fargo), Wells Fargo (NYSE:WFC) is the bank that best exemplifies these attributes.
There's a reason for that, starting with Warren Buffett's initial purchase of shares in 1989, Wells Fargo has become Berkshire Hathaway's (NYSE:BRK-B) largest public market shareholding (on a cost basis, it's No. 2, behind IBM). Conversely, Berkshire is Wells' largest shareholder, with a 9.1% stake.
Explaining his initial purchase in his 1990 letter to shareholders, Buffett wrote:
In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate. Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices. With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen.
A quarter-of-a-century on, and Buffett's opinion hasn't changed. In 2012, he told Bloomberg Television:
I like Wells better than anything by far. We bought Wells this year. We've bought Wells month after month -- well, not every month -- for a lot of years. I like loading up on the one I like best.
That process is ongoing: In the first quarter of this year, Buffett increased Berkshire's position by 1.5% to 470.3 million shares.
(For investors who are interested in adding shares of Wells Fargo to their portfolio, the current valuation, less than 12 times next year's earnings-per-share estimate, looks more than fair.)
Sean Williams (U.S. Bancorp): As my Foolish colleague Alex notes above, it's pretty hard to find a more stable banking institution than Wells Fargo. However, I'd opine that U.S. Bancorp (NYSE:USB) is an extremely close second, and that it could very well stand the test of time regardless of what curveballs the economy throws its way.
Perhaps the biggest defining factor for U.S. Bancorp is that it stays away from risky investments. When derivatives were the hot trade on Wall Street in the late 2000s (and subsequently tanked a number of big banks), U.S. Bancorp was nowhere to be found because it stuck to the bread and butter of banking: deposits and loans. In the second quarter alone, U.S. Bancorp reported $54.2 billion in new lending activity during the quarter, as well as nearly 9% year-on-year deposit growth. Best of all, the majority of the deposits it receives are typically low-cost non-interest-bearing, or bear a very low interest rate.
U.S. Bancorp also isn't intricately tied to the housing market. Its nearly quarter-trillion-dollar lending portfolio in Q2 consisted of $66 billion in residential mortgages, second mortgages, and home equity lines of credit. With housing perpetuating the 2007-2009 meltdown, it's comforting to know that U.S. Bancorp has a diversified loan portfolio that isn't overly reliant on home loans.
Lastly, the performance is there to back up U.S. Bancorp's valuation. Among big banks, U.S. Bancorp has the highest return on equity over the trailing-12-month period, and it returned a whopping 76% of profits in Q2 2015 to investors through its dividend and share buybacks. Mind you, its payout ratio is only 32%, meaning there's plenty of room for dividend expansion down the road.
If you want a set-it-and-forget-it bank stock, consider U.S. Bancorp.
Dan Caplinger (Goldman Sachs): It's easy to criticize Goldman Sachs (NYSE:GS) for its behavior in the years leading up to the financial crisis, with the investment bank earning the lion's share of attacks from ordinary Americans for what many consider to have been questionable tactics in dealing with clients and taking its own investment positions. Yet despite the fallout from the financial crisis -- and the billions in legal settlements and related liabilities the investment bank ended up paying -- Goldman Sachs has held onto its reputation among current and potential clients as a force to be reckoned with in the investment banking world, and many customers would rather have the bank on its side than try to go up against it.
Even with its long history, Goldman hasn't been afraid to move into new businesses. The most recent venture the investment bank has talked about moving into is online lending, with direct-to-consumer loans that could help cut out intermediary expenses and reap potential rewards from higher interest rate margins. At the same time, focusing on high-net-worth individuals and high-end business clients continues to be Goldman's bread and butter, and the panache Goldman Sachs has displayed appeals to those seeking to make their riches on Wall Street.
As long as people want to make money, Goldman Sachs will have a place atop the investment banking realm.
Alex Dumortier, CFA, has no position in any stocks mentioned. Dan Caplinger owns shares of Berkshire Hathaway, which the Motley Fool also owns and recommends. Sean Williams has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.