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3 Reasons Bank Stocks Are Smart Investments

By Jay Jenkins - May 14, 2016 at 8:28AM

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It's high time we reflect on the reasons bank stocks belong in your portfolio.

There are a lot of different investment options available today, and with all that choice it's easy to dismiss bank stocks as villains, as "too big to fail," or simply as "too risky."

While there are certainly just reasons for those sentiments, bank stocks in general can be a great place to invest your money. Here are three fundamental reasons I think bank stocks are smart investments.

Long-tail revenue
In many industries, when a company completes a sale, that transaction marks the end of the financial benefit for the company. A phone manufacturer, for example, makes money only when someone buys a new phone. To make more money off of that customer, the phone maker must sell the customer another phone. Over time and with competition, that can be a challenging proposition.

For banks, the revenue model has a much longer time horizon. When a bank originates a loan, it will typically collect a fee at the time the loan closes. Then, every single month until the loan is paid off, the bank makes even more money from the interest that accrues each and every day. That means banks today are still generating revenue from sales that were closed years ago.

At the same time, banks have the ability to sell loans to investors in the secondary markets, oftentimes at a premium price. This gives banks the ability to choose whether they want to hold on to a loan for the long term or to cash in on the value of future loan payments at any given time. If the bank does choose to cash in by selling a loan onto the secondary market, the cash generated is not only profitable, it's also a quick way to raise money to fund even more loans and repeat the cycle.

Altogether, this is a powerful tool to smooth earnings over time, manage balance sheet risk, and fund growth.

Cheap deposits
Companies generally have two options to fund their operations -- capital from investors or debt. Banks have a third, powerful choice: customer deposits. Deposits are a very cheap funding source in normal times and are particularly so in today's low interest rate environment.

JPMorgan Chase's (JPM -2.33%) $2.4 trillion balance sheet, for example, was funded by $1.3 trillion in customer deposits as of March 31, 2016. Of those deposits, 30.6% paid no interest whatsoever. That's free money for the bank to invest, fund loans, and generate cost free yield. Many of the remaining deposits pay only a pittance in today's environment, oftentimes as low as 0.1% per year.

This amounts to free money that JPMorgan and other banks are able to put to work at a cost that other industries simply cannot match.

Diverse revenue streams
Third, banks are excellent at finding ways to supplement and diversify their revenue streams. This is a natural evolution past the lending business model, because loans are a highly cyclical business. When the economy booms, loans are readily available, in demand, and repaid consistently. However, during recessions or economic slowdowns, businesses and individuals tend to deleverage, reduce demand, and increasingly default on their loans.

To counteract the credit cycle, banks have learned to expand their sources of revenue. Bank of America (BAC -2.29%), for example, actually generated more non-interest income than net interest income in this year's first quarter. Non-interest income was $10.3 billion versus the bank's $9.2 billion in net interest income. The bank's investment banking division, Bank of America Merrill Lynch, is a large driver here, bringing in fees for investment management, advisory, trading, and other non-lending revenue streams. Bank of America also generates revenue from selling insurance products, collecting fees on deposit products, credit and debit card fees, and more.

It's not just the largest banks such as Bank of America either. Smaller banks are also able to supplement their core lending businesses with diverse revenue streams. First Republic Bank (FRC -1.14%) bases its business first and foremost on originating jumbo-sized mortgage loans to high-net-worth clientele in nine select markets around the Unites States. Yet even with its heavy, core focus on the mortgage loan, the bank is still able to successfully cross-sell an array of value-added, non-loan products to its customers. The result is a diverse revenue stream of interest income from loans, interest from investments (think bonds and mortgage-backed securities), investment management income, and brokerage fees, along with a host of deposit, loan-servicing, trust, and other fees.

At the end of the day, the most important consideration is quality
For these reasons and more, I think bank stocks can be a great place to find-long term, winning stocks. Therefore, the next step is finding the right bank stock out of the thousands of options in the market today.

My recommendation is to start your search by looking for proven, high-performing banks. These banks have shown that they are capable of taking full advantage of their competitive edge throughout all phases of the credit cycle.

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Stocks Mentioned

Bank of America Corporation Stock Quote
Bank of America Corporation
BAC
$31.13 (-2.29%) $0.73
JPMorgan Chase & Co. Stock Quote
JPMorgan Chase & Co.
JPM
$112.61 (-2.33%) $-2.69
First Republic Bank Stock Quote
First Republic Bank
FRC
$144.20 (-1.14%) $-1.66

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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