On today's episode of Industry Focus: Financials we take a look at the third-quarter earnings of the nation's "too big to fail" banks, only one of which increased revenue last quarter. But that doesn't mean the other banks aren't headed in the right direction, as well. Tune in as The Motley Fool's John Maxfield and Gaby Lapera dive into the numbers.

A full transcript follows the video.

 

Gaby Lapera: Hello, everyone! Welcome to The Motley Fool's Industry Focus, financials edition. Today we're talking about everyone's favorite topic: bank earnings.

Revenue declined in most banks. Do you want to talk a little bit about that?

John Maxfield: Yeah. This was a quarter where, we came into this quarter knowing that it was going to be a difficult one for the banks for two reasons in particular. The first was that trading revenues were down in a lot of the big banks, and that was a result of the market volatility surrounding the concerns about China's growth.

I think just this morning we saw some disappointing figures. It looks like they only grew 6.9% in their latest period relative to the plus 10% rates that we were used to a couple of years ago. The second reason was that interest rates were still low. When you have banks that earn a lot of money from owning interest earning assets; low interest rates will have a big impact on your revenue.

For those two reasons we saw revenue fall at virtually all of the big banks of the United States last quarter.

Lapera: Absolutely. Something to keep in mind if you're listening; most banks have loans making up to 50% of their asset making portfolios. When interest rates are as low as they are, it just doesn't make as much money. It's kind of a catch 22 for banks because people complain when rates are too high, and then the banks complain when the rates are too low.

Maxfield: That's exactly right. What's interesting about this too is, the traditional business model of banks is, what they wanted is a really low short term interest rate and then a really high long term interest rate. All of that changed during the high inflation period in the late '70s and early '80s. Now what banks are looking for are higher short term rates. They index all their commercial loans off those low, short term rates.

The higher the short term rates, the more interest they earn. The more interest they earn, to your point, because they make up about half the interest that banks earn from their asset portfolios; that makes up about half of their total revenue. That will increase as well as short term rates increase.

Lapera: Looking at the big four banks, which are J.P. Morgan (NYSE: JPM), Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC), and Goldman Sachs (NYSE: GS); out of all of those one of them had an okay quarter.

Maxfield: Yeah. Truth be told, a couple of them had a pretty decent quarter, it's just that the comparisons were difficult. The bank that a really good quarter was Wells Fargo. Just to give you some statistics, J.P. Morgan Chase which is a phenomenally run bank, its revenue fell on a year over year basis by 6.9%. That's a pretty substantial decline in revenue. Bank of America's fell 2.5%, Citigroup's (NYSE: C) fell about 5%.

Wells Fargo, however, grew by 3%. You're looking at that wondering how in the world Wells Fargo made that happen. Let me dig into the explanation for why that happened. That's because Wells Fargo is a traditional bank, so it relies on its assets portfolio, and therefore interest rates more than a J.P. Morgan Chase, or Bank of America, or Citigroup which all have substantial Wall Street operations to counterbalance their traditional banking operations.

What Wells Fargo was able to do was, because it's still such a strong, competitive position relative to its competitors coming out of the financial crisis; it's still on an aggressive growth case. Whereas Bank of America and Citigroup are not only not growing, but they're still in that receding period where they're trying to get rid of bad assets on their balance sheets.

On a year over year basis, Wells Fargo grew its interest earning assets by $123 billion worth. To put that into context, that's roughly the size of the 12th largest bank in the United States of America. That's just the one year growth in Wells Fargo's assets. Even though it's earning less on each asset that it holds in this portfolio, because it has so many more; it's still earning more revenue from it.

Lapera: To reiterate for our listeners, it's earning less because of the low interest environment that we're in right now. Like Maxfield said, because they own so many more, they're still making more in bulk…

Maxfield: That's exactly right.

Lapera: Let's talk a little bit about J.P. Morgan and those other banks that do rely a bit more on trades.

Maxfield: J.P. Morgan Chase, if you're just looking at those topline changes in its revenue you would say this bank had a horrible quarter. Its revenue fell by any other bank -- I think the exception was Goldman Sachs. The reason was, again, J.P. Morgan Chase stands at the intersection of global finance. It has these enormous Wall Street operations and it's serving as a market maker for companies that are looking to buy and sell whatever large institution or security that you're talking about.

When fears of China came out, what happened was, there was a lot of volatility in the credit markets. When you have a lot of volatility in the credit markets, investors in them will back up to stay out of the mix. When they back up, that volume decreases. J.P. Morgan Chase would be serving as a market maker and administering.

Because that volume decreases and therefore its commissions decrease, it's going to see a large drop. That's exactly what J.P. Morgan Chase saw. However, it's important to keep in mind that even a "bad quarter" for this bank, it's still an excellent bank. I think it earned 15% on its equity. It returned something on an annualized basis, and returned 15% on its equity.

To put that into context, typically what you want to see from a bank is that it's exceeding its cost of capital. If it's exceeding its cost of capital on its profitability that means it's creating value for its shareholders. Whereas, if it's under its cost of capital it's return on equity is under its cost of capital, that means it's destroying value for its shareholders.

Lapera: J.P. Morgan Chase did exceed its cost of capital by about 4%.

Maxfield: That's right. J.P. Morgan Chase's estimated cost of capital is around 11%. The fact that it's exceeding it -- and a lot of other banks are not only not exceeding it, but they're underperforming by a large margin. Something important for J.P. Morgan Chase's investors to keep in mind is, even in a bad quarter you're still looking at an extremely profitable bank.

Lapera: I think it's something for people to remember that, when you look at earnings it's how the company is doing at that split instant in time. It's not looking at what the company's long term prospects are. Of course, if they have a terrible quarter and they go bankrupt then that's it. In general, for really great institutions like J.P. Morgan that you're investing in for the long term, you have to put everything into context.

Maxfield: Quite frankly, as an individual investor, you could totally ignore quarterly results. We talk about them because it's our job to inform investors of what's going on, but if you're invested in a great company like Wells Fargo, or J.P. Morgan Chase you could literally go a decade without looking at their quarterly results. It's probably going to be a better thing for you to do because it won't encourage you to buy or sell anything quickly.

To Gaby's point, it's a good thing to keep in mind that, while quarterly results provide a window into the latest performance of whatever company you're invested in, you shouldn't use that as a sole reflection on the value, or the quality of that company.

Lapera: The other thing to keep in mind is, one of the things that goes hand in hand with earnings season is analysts' expectations. Sometimes companies beat analyst's expectations, sometimes they don’t and sometimes people react to that news without really thinking about how the company has done in the larger picture.

Maxfield: Yeah. Think about it. If you just read your typical earnings release written by whomever it is, or whatever publication it is; almost invariably at the beginning, often times even in the title they talk about how banks, or whatever company it is, beat expectations, or missed expectations. What they're referring to is, as a quarter goes along, the analyst that follows specific companies come out with profit targets for that company that they're looking for when that company reports earnings. That's generally expressed in earnings per share.

If all the analysts come out with overly optimistic results and a bank, or any other type of company misses it, you'll typically see a relatively sharp decline in its share price upon the release of the publication of the earnings release.

Lapera: That can even be advantageous for long term investors because that's a great time to buy. If there's nothing fundamentally wrong with the company.

Maxfield: That's exactly right. The thing to keep in mind is, these are just analysts like me, or you, or anybody else. You're really just trying to make an educated guess about what a company is going to earn. It's difficult to understand, but you don’t' have any type of authority over the matter. You may know more about it as an analyst, but you don’t have any authority over the matter.

It's not so much that a bank, or company misses, or beats expectations; it's that the expectations missed or beat the reality. It's reverse to how we're inclined to think about them.

Lapera: Exactly. Long story short for our listeners out there, when you go to evaluate a company, sure; look at the earnings reports, the 10Ks, the 10Qs, but when you think about how they're doing, look at it in the long term. Compare them against how they've been doing historically. Look at the metrics for the company and maybe take analysts' opinions into account, but really you need to formulate your own thoughts on the matter.

Maxfield: Yeah. What you're looking for is a company that can be more profitable than the other companies in its industry, over a sustainable amount of time. That's what it's all about. That's how you pick a winning investment over years. Analysts' expectations have nothing to do with that.

Lapera: We do have time to cover one more topic today. Do you want to talk a little bit about Bank of America?

Maxfield: Yeah. As listeners may know, and people who read my writing, I follow Bank of America pretty closely and write quite a bit about them. What I found so interesting from this quarter was a point that CEO and Chairman Brian Moynihan stressed on the quarterly conference call. It was the fact that, did Bank of American have an incredible quarter? No.

I think its return on equity for the quarter was 0.82%, when you want a bank to be 1% or higher on its return on assets. It didn't have a great quarter, looking at it as a snapshot. However, if you couple it up with the three previous quarters, building it out to a full year although it's straddling 2014/2015; it was the first time since the financial crisis that Bank of America generated a solid profit for four quarters in a row.

This builds on what we talked about last quarter when Bank of America reported. It looks to me like Bank of America has really turned the corner, finally, and put the majority of those liabilities that were weighing on its earnings that relate to financial crisis, has put those in the rearview mirror.

Now, that doesn't mean that tomorrow Bank of America will be generating 1.5% returns on assets. What it does mean is that you're probably going to see consistent profitability for the most part going forward, and those profitability metrics are probably relatively consistently going to edge up. That's a good thing for shareholders in Bank of America, and for perspective investors because it still trades for a substantial discount to book value.

Lapera: This is also a really good sign for future economic growth for the entire country.

Maxfield: Yeah. That's a really good point. When you think about what dictates economic growth, it's a function of three things -- at least the way economists think about it -- it's a function of labor, capital, and productivity. If you increase any one of those, holding all else equal, you're going to increase your economic growth.

Banks are so important because they increase capital. They don’t actually create capital, but they aggregate the savings of the millions of Americans spread around the country who put a little bit of money into their savings account and then banks put all that together and lend it out for people who want to buy houses, which pushes economic growth, or corporations who want to make business investments pushes economic growth.

Banks really stand at the narrows in terms of economic growth. When you have Bank of America, which is your largest consumer bank in the country, still ailing from the financial crisis and is thereby not able to grow its portfolio as quickly as it wants to; that's really going to impact your economic growth.

Even more generally than bank earnings, Bank of America and Citigroup's recovery is a very, very positive and important thing for the United States economy.

Lapera: That's all we have time for today. Thanks for joining us. I hope you liked this week's episode. Write to us at IndustryFocus@Fool.com to let us know what you think, or to tell us a joke about banks because banks could definitely stand to be funnier. Next week we'll be talking about competitive advantages. Get excited. As usual people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So, don’t buy or sell stocks based solely on what you hear. Thanks everyone, and have a great week!

Gaby Lapera has no position in any stocks mentioned. John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool recommends Bank of America. 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.