Banks can seem like rather complicated businesses, and in many ways they are. However, the basic ideas behind the banking industry and how these businesses make their money are easy to understand. With that in mind, here's an overview of the different types of banks, some important metrics investors should know, and three great beginner-friendly bank stocks to keep on your radar.
The three categories of banking businesses
- Commercial banks: These are banks that provide services to consumers and businesses, such as checking and savings accounts, auto loans, mortgages, certificates of deposit, and more. The primary way a commercial bank makes its money is by borrowing money at a relatively low interest rate and lending it to customers at a higher rate. While commercial banks make the bulk of their money from interest income, many also collect substantial fee revenue from things like loan origination fees, ATM surcharges, and account maintenance fees. It's important for investors to note that commercial banking is a cyclical business -- when recessions (and pandemics) hit, unemployment rises and consumers and businesses often have trouble paying their bills.
- Investment banks: These banks provide investment services for institutional clients and high-net-worth individuals. Investment banks help other companies go public through IPOs, issue debt securities, and advise on mergers and acquisitions, and they earn fees for doing these things. Investment banks typically also make money from trading in equities, fixed-income securities, currencies, and commodities. They also typically have wealth management businesses and often have substantial investment portfolios of their own. Unlike commercial banking, investment banking tends to hold up quite well during recessions. In fact, when markets get volatile, investment banking often does better.
- Universal banks: A universal bank is one that has both commercial and investment banking operations. Most large U.S. banks are universal banks. While commercial banks get the bulk of their profits from interest income and investment banks primarily rely on fee income, universal banks enjoy a nice combination of the two.
Obviously, these are simplified definitions. Banks have many other ways to generate revenue. For example, many banks offer safe deposit boxes for lease to their customers, and some make money through partnerships with third-party companies. However, at their core, these are the main ways that banks make their money.
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Three top bank stocks to put on your radar in 2021
Hundreds of banks trade on the major U.S. exchanges, and they come in various sizes, geographic locations, and focuses. While there are some excellent choices in the investable universe, here are three beginner-friendly bank stocks that could deliver excellent returns for years to come:
Bank of America
Bank of America has been one of the most impressive turnaround stories in the post-financial-crisis era, even as falling interest rates put pressure on its profitability. In recent years, the bank increased its loan portfolio at rates well ahead of its peers, and the company has made major improvements in efficiency while building out its online and mobile technology. Bank of America's asset quality is excellent, and with a relatively high concentration of deposits that don't pay interest, the bank is in a strong position to benefit if and when interest rates rise.
JPMorgan Chase is hands down the most profitable of the big universal banks, and it’s also the largest bank by market capitalization in the U.S. The bank has operations in just about every area of both commercial and investment banking, and it has done a particularly great job of expanding its credit card and auto loan businesses in recent years. JPMorgan Chase has also done an excellent job of embracing new technologies, and it has made some key investments in financial technology, or fintech, companies.
U.S. Bancorp is primarily a commercial bank, with income from loans and other consumer banking products making up virtually all of its revenue. Not only is U.S. Bancorp (known to most Americans as U.S. Bank) focused on consumer banking, it consistently produces some of the most impressive profitability and efficiency metrics in the sector and has been an excellent dividend stock for investors. Because it doesn't depend on investment banking, which is generally the more volatile side of the banking business, U.S. Bancorp's profitability and revenue tend to be more predictable and consistent than the other two banks on this list.
Important metrics for bank stock investors
If you're looking to invest in individual bank stocks, here are a few metrics that you might want to add to your toolkit:
- Price-to-book (P/B) value: An excellent valuation metric to use with bank stocks, the price-to-book, or P/B, ratio shows how much a bank is trading for relative to the net value of its assets. It can be used in combination with the profitability metrics discussed next to give an overall picture of how cheap or expensive a bank stock is.
- Return on equity (ROE): The first of two common profitability metrics used with bank stocks, return on equity is a bank’s profits expressed as a percentage of its shareholders’ equity. Higher is better; 10% or above is generally considered sufficient.
- Return on assets (ROA): This is a bank’s profit as a percentage of the assets on its balance sheet. For example, if a bank made a $1 billion profit for a given year and had $100 billion in assets, its return on assets would be 1%. Investors generally want to see an ROA of 1% or higher.
- Efficiency ratio: A bank’s efficiency ratio is a percentage that tells investors how much the bank spent to generate its revenue. For example, a 60% efficiency ratio means that a bank spent $60 for every $100 in revenue it generated. You get the efficiency ratio by dividing noninterest expenses (operating costs) by net revenue, and lower is better.
The cyclicality of bank stocks
Banks can be a great place to invest, especially in strong economies. When consumers are confident to spend and unemployment is low, profits tend to grow and loan defaults are typically kept in check. On the other hand, banks tend to perform quite poorly during recessions and other uncertain times. In investing terms, this means banks are a cyclical business.
There are a few reasons banks tend to perform poorly during recessions and other difficult economic climates. For one thing, they could face a wave of loan defaults if unemployment rises. Second, consumers tend to pump the brakes on spending during recessions, which leads to lower demand for loans. Finally, interest rates tend to decline during tough times, which is bad news for banks' profit margins.
It’s also worth mentioning that some parts of investment banking -- specifically trading and underwriting -- tend to do better in turbulent times. Banks such as JPMorgan Chase and Goldman Sachs (NYSE:GS) that have large investment banking operations could be helped by this, while banks that largely focus on commercial banking, such as Wells Fargo (NYSE:WFC), could be at a temporary disadvantage.
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These businesses are recession-resistant and have long-term investment appeal.
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Warren Buffett loves banks
Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) CEO Warren Buffett is known as one of the best stock investors of all time, and for good reason. During his 55 years at the helm of the company, Buffett has delivered annualized returns more than double those of the S&P 500, and the investments he’s chosen for Berkshire’s massive stock portfolio over the years are a good reason why.
If you take a glance at Berkshire’s stock portfolio, you’ll notice one major trend -- Buffett owns quite a few bank stocks. Berkshire owns stakes worth $1 billion or more in four different bank stocks, including a very large stake in Bank of America.
The bottom line on bank stocks
While it’s not necessarily a smart idea to buy any particular stock just because a billionaire owns it (even Warren Buffett), there does appear to be some value in the banking industry in 2021. So, if you don’t have much exposure in your portfolio, one or more of the rock-solid banks discussed here could be a good fit for you.
How do banks make money?
At their core, banks make their money in two main ways -- commercial banking and investment banking. Commercial banking refers to the banking products and services that banks provide to individuals and businesses. Investment banking refers to services a bank provides to corporations, governments, high-net-worth individuals, and other entities that go beyond those commercial banking activities.
Are bank stocks cyclical?
The short answer is yes. Bank stocks are generally affected by recessions for a couple of reasons. First, interest rates tend to fall during recessions. Second, and more important, unemployment tends to rise during recessions, and more consumers run into financial trouble.
However, the longer answer is that every bank is different. Consumer banking (taking in deposits and lending money) is highly cyclical, and this is especially true for banks that specialize in riskier forms of lending such as credit cards. On the other hand, investment banking tends to do even better during turbulent times, so banks that have large investment banking operations tend to see profits hold up quite well.
How do you analyze bank stocks?
When trying to analyze a particular bank stock, it's a good idea to focus on four main things:
- What the bank actually does
- Its price
- Its earnings power
- The amount of risk it's taking to achieve that earnings power
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