Bank stocks have quietly become some of the market's biggest winners. As the Federal Reserve has slowly increased rates a quarter-point at a time, rising interest rates have helped the banking industry grow net interest income, driving double-digit profit growth.
Let's look at the financial sector from top to bottom, explain how banks work, and consider why you might want to invest in banks. Then we'll give you five bank stocks to consider for your portfolio.
The basics of banking
At their core, banks are rather simple: They take deposits from individuals, businesses, and governments, and they use the money to make loans to individuals, businesses, and governments. Banks are middlemen for money. If you have $10,000 of cash, you can deposit it at a bank and earn interest. If you need to borrow $10,000, you can go to a bank to borrow it and pay interest.
Banks make the bulk of their money from the "spread" between what they pay on their deposits and earn on their loan portfolios. The old joke is that banks operate under a "3-6-3" model in which they borrow at 3%, lend at 6%, and hit the golf course by 3 p.m.
Of course, banks also make money from a variety of fee businesses. They charge fees for basic banking services -- think account fees and ATM charges -- but they also help individuals manage retirement portfolios, and they help businesses accept debit and credit cards. The largest make money by helping companies raise money by selling stocks and bonds to the public. In short, if it involves money in some way or form, a bank is probably involved.
Why invest in banks?
Banks can be a great industry to invest in. Just ask Warren Buffett, easily the greatest investor to ever live, who has stuffed his portfolio to the brim with banks and keeps buying more. There are many reasons you might want to invest in banks, aside from following Buffett's lead:
- Practicality. Investing in banks requires some specific knowledge, but if you can understand one bank, you can probably understand them all. The business of banking is highly commoditized, which means most banks are doing the same things as their peers, making it easy to compare them to one another.
- Interest rates. Bank stocks are some of the very few investments that tend to rise in value when interest rates increase. So when rate increases weigh on your stock and bond portfolio, rising rates will give life to your bank stocks, which makes banks a great way to diversify your portfolio.
- Dividends. Bank stocks can be dividend machines, particularly the largest U.S. banks, which earn more money than they can reliably reinvest to support deposit and loan growth. In recent years, the largest U.S. banks have paid out virtually all of their earnings to shareholders by paying dividends and buying back stock.
- Choice. Don't like a certain bank? No problem: There are several hundred more for you to choose from. The United States has more banks than virtually any other country in the world, so you won't have to look too hard to find yet another bank stock to analyze.
- Local investment. Your knowledge of the economy in the 50 or 100 miles surrounding your home can be a huge asset when investing in banks. With so many publicly traded banks on the market, the odds are good that one of your hometown banks is publicly listed. That bank would be a good place to start your analysis, since you probably have a good understanding of local employment trends, real estate prices, and so on.
The risks of investing in banks
Banks are inherently cyclical. Their profits are driven by the ups and downs of interest rates, as well as the performance of the economy as a whole. During economic expansions, banks benefit from increased loan demand and lower loan losses as fewer people and businesses struggle to make ends meet.
However, during periods of economic distress, bank earnings naturally tumble. As a rule of thumb, the very best banks will earn about 1% to 2% on assets, meaning that for every $1 of assets they have, they'll report $0.01 to $0.02 in net income. Thus, even a small increase in bad loans can have a huge impact on their bottom-line profitability. At the depths of the financial crisis in 2009, if you added up all the profits or losses of all banks in the United States, you'd find that they lost money as a whole.
The chart shows the earnings of all banks divided by the assets of all banks for each year. You'll notice that profits dip during recessions (1991, 2001, and 2008). The more severe the recession, the greater the drop in bank profits. The short recession of the early 2000s barely registers on the chart compared with the plunge during the Great Financial Crisis. The dip in the early 1990s was accompanied by falling real estate prices in certain areas, particularly in Texas and California, where a glut of commercial real estate led to plunging prices and bad loans.
This point leads perfectly into another important thing to understand about banks: The banking industry is highly local. A bank in Detroit is likely to have different growth prospects and outcomes than a bank in Santa Clara, California. The best bank in a place where unemployment is 10%, home prices are falling, and residents are fleeing will probably underperform the worst bank in a geographic area where unemployment is 4%, home prices are soaring, and the population is increasing.
Important metrics for bank investors to know
Bank stocks are unlike few others. Whereas most companies make their money by selling a product or service, banks make their money by taking risks with money. Thus, analyzing a bank stock requires different financial metrics from what you'd find in other industries.
Here are five of the most important metrics for banks.
1. Net interest margin (NIM). This figure is designed to show the difference between what a bank earns on its assets -- loans and securities -- minus what it pays for deposits and other borrowings. If a bank has $500 million of earning assets, earns $30 million in interest, and pays $10 million in interest, it would have a net interest margin of 4%: ($30 million-$10 million)/($500 million) = 0.04, or 4%.
I like to benchmark banks against the national average. Every quarter, the Federal Reserve publishes the net interest margin all banks earn. In the third quarter of 2018, for example, the average NIM for U.S. banks was 3.33%.
Banks that earn higher-than-average NIMs may do so because they have cheap deposits, or because they make riskier loans. Credit card companies, for example, earn higher NIMs than commercial banks that make safer loans to businesses. A bank may earn lower-than-average NIMs because it makes safer loans, or because it has to pay depositors a higher rate on their deposits.
The trajectory of a bank's NIM is also important, particularly when interest rates are rising and falling. The Fed started increasing rates in 2016, giving lift to the banking industry's net interest margin. Banks that have seen their NIM increase at a rate faster than average are probably good bets for banks that will capitalize on future rate increases.
2. Return on assets (ROA): Return on assets is simply a bank's annual net profit divided by the assets on its balance sheet. Thus, a bank that earns $2 million on assets of $100 million would have a return on assets of 2%. Generally speaking, an ROA above 1% is good, and an ROA above 1.5% is exceptional. Many bank investors, Buffett included, consider this one of the best measures of a bank's true profitability.
ROA is often used in other industries, but it's especially important in the banking industry, as there is a very direct link between the assets a bank has on its balance sheet and its profitability. Banks that generate higher returns on assets over long periods may have a competitive advantage stemming from their ability to analyze risks, hold down expenses, or earn fees from non-lending business lines, or from their ability to win deposits from competing banks.
3. Nonperforming loans (NPLs): A nonperforming loan is generally one in which the borrower has failed to make contractual payments for more than 90 days. Banks typically place nonperforming loans on "non-accrual," which means they stop recognizing income from the loan because it may not be collected.
Any bank, no matter how well-managed, will have some loans that simply go bad. Investors often use a bank's NPL ratio -- non-performing loans divided by all loans -- to see how the bank's loan portfolio is performing.
The NPL ratio is best used to compare a bank's recent performance to prior periods (for example, a bank's NPL ratio in 2019 versus the same bank's ratio in 2011) or to compare similar loan types across lenders (for example, one bank's mortgage NPLs versus another's).
4. Tangible book value (TBV): This financial metric is useful because it tells you what a bank would be worth if it were liquidated -- if all the assets were sold, liabilities were paid back, and whatever was left over was distributed to shareholders.
Bank investors often divide TBV by the number of shares outstanding to arrive at TBV per share. A bank's share price compared to its TBV per share is useful as a valuation metric. If a bank trades at 1.5 times TBV, then you know shares trade at a 50% premium to the bank's liquidation value.
Banks that earn higher returns on assets, have more growth opportunity, and/or have a history of taking better risks in their loan portfolios typically trade at higher multiples of TBV than slower-growing banks and banks that earn poor returns on assets.
5. Efficiency ratio: The efficiency ratio is designed to tell you how much a bank spends to generate a dollar of revenue. The formula is as follows: non-interest expenses/(net interest income + non-interest income).
Banks have to spend money to generate revenue. A bank needs to have, and maintain, ATMs to earn fees. It needs to have loan officers and credit analysts if it wants to lend. Taking in deposits often requires adding more branches. (Yes, even today, branches still matter.)
Unlike some other ratios on this list, a lower efficiency ratio is better. If a bank has a 40% efficiency ratio, that means it spends 40% of its revenue on non-interest expenses, such as office space and labor. But like other ratios, this one is most useful when used to measure a bank's performance over time, or in comparing banks with similar business models.
If a bank CEO announces a a three-year plan to "be more efficient" and the efficiency ratio only increases, well, you have a way to know things aren't going according to plan. If one community bank in your city has a 60% efficiency ratio and another is at 80%, even though both make the same kind of loans and have the same deposit-gathering strategy, then the second bank may require more investigation. It could just be that the second bank has recently opened new branches that have only begun to take in more deposits, or it could be something less benign, such as oversized paydays and car allowances for its executives.
Why banks in 2019?
There are many positive trends in the banking industry that should bode well for profits in 2019 and beyond.
- Lower taxes. When the U.S. government reduced corporate taxes to 21% from 35%, the resulting tax regime was extremely favorable for U.S.-based banks. Over time, one would expect that the advantage of lower taxes will go away as banks start competing more aggressively on rates for deposits and loans, but for now, banks are practically printing money thanks to the step down in tax rates that took effect in 2018.
- Deregulation. In the years following the financial crisis of 2008, regulators clamped down on the banking industry. They required banks to hold more capital to protect against losses, made them stop offering certain types of riskier loans, and took aim at key sources of income, such as debit card fees. As time goes on without any banking disasters, rules that restricted risk-taking at major U.S. banks could be reversed, allowing banks to add more loans to their balance sheets to drive profit growth.
- Rate increases. Additional rate increases could bolster bank profits, particularly for banks that tend to make floating rate loans -- meaning the interest rate changes with the market rate -- as well as banks that have low- or no-cost deposits that allow them to capture all the benefit of rising rates as profit.
The banking industry has come a long way over the past decade. Banks have aggressively eliminated expenses and derisked their balance sheets by letting riskier loans run off and adding more capital to their balance sheets to stomach loan losses.
With that in mind, here are some banks that could be great buys in 2019 and beyond.
Quick Case for Buying This Bank
Bank of America (NYSE:BAC)
National bank that benefits from being big
SVB Financial (NASDAQ:SIVB)
Tech bank with unique exposures
First Republic Bank (NYSE:FRC)
Fast-growing bank for wealthy Americans
Slow and steady regional bank
Wells Fargo (NYSE:WFC)
National bank with some fixable problems
1. Bank of America: a big bank to buy and hold
In a commodity industry like banking, low-cost producers have an edge. For banks, the biggest advantage primarily comes from scale. Large banks can spread the costs of administrative tasks, branch networks, ATMs, and other costs across a larger base of assets, thus operating more efficiently than their smaller competitors. In an extreme case, a one-branch bank that has $1 billion in deposits will have expense advantages over a one-branch bank that has $100 million in deposits. The costs to run a bank don't scale directly with the size of the bank, giving bigger banks an edge.
Few banks have the scale to match Bank of America, which has more than 10% of all deposits in the United States. By spreading its expenses across a large balance sheet, Bank of America is extremely efficient. In 2018, its consumer banking unit had an impressive efficiency ratio of less than 50%, an impressive result that can only be achieved with scale.
Bank of America's performance has improved markedly since the financial crisis. The bank spent the better part of the past decade investing in its mobile banking features, which enabled it to serve its customers while closing down roughly one-fourth of its branches. The bank also dialed down the risk in its loan portfolio, cutting back on risky credit card and home equity loans, and lending more to businesses than to consumers.
The biggest mistakes Bank of America made going into the financial crisis were acquiring other banks at high prices. The Charlotte, N.C.-based bank acquired Countrywide and Merrill Lynch in costly and poorly timed acquisitions. But investors don't have to worry about acquisitions anymore: Bank of America holds more than 10% of the nation's deposits, which means it can't legally acquire another bank even if it wanted to.
Given its size, basic mathematics suggest Bank of America is unlikely to grow much faster than the banking industry average, but investors may still eke out favorable returns. With acquisitions ruled out, Bank of America can do little more than grow its loan portfolio at a slow single-digit rate while showering shareholders with rich dividends and share repurchases.
2. SVB Financial: a riskier "tech" bank
Some banks have unique exposures that make them different from their peers. SVB Financial, the parent company of Silicon Valley Bank, is one such banking institution, given that it makes its money from being the bank for Silicon Valley tech companies and the funds that invest in them.
Whereas most banks make only plain-vanilla business loans, SVB Financial often lends to riskier start-ups on terms that give it the right to buy stock in the company at a later time. That gives it additional upside potential when it finances companies that go on to be runaway winners. The company has monetized stakes in companies that include Fitbit, Roku, and Acacia Communications, among others, booking large, but less predictable, profits.
SVB Financial's exposure to the technology industry and the financial firms that invest in high-flying tech companies does make it a little riskier than the average bank. But its tech focus also helps, particularly when it comes to attracting quality deposits that help it earn more money when rates rise.
This is also one of the most rate-sensitive banks on the market. More than 80% of its customers' deposits are non-interest-bearing, meaning it doesn't pay a dime in interest to its customers for keeping those balances at the bank. In the first nine months of 2018, rising rates helped drive its net interest margin up from 3.2% to 3.62%, as its interest income rose considerably faster than its interest expenses.
A focus on high-growth technology companies means this bank's fortunes are inherently tied to wealth creation in Silicon Valley. Tech companies have found it easy to raise more and more money, but a slowdown in venture capital activity could turn the boom into bust. For this reason, I regard it as the most speculative bank on this list.
3. First Republic: a fast-growing bank for the wealthy
High-growth banks are few and far between. An industry-watcher rule is that deposits and loans at the nation's banks will generally increase at a rate equal to economic output over long periods. Thus, if, over a 10-year period, the economy grows at 4% per year, assets in the entire banking industry are likely to increase at about 4% per year. To grow any faster than the average, banks will have to steal deposit and loan market share from other institutions.
Small banks are most likely to exhibit faster rates of growth. One intriguing and fast-growing bank is First Republic Bank, which caters to high-net-worth households and commercial customers in major metropolitan areas. The bank's largest markets include Silicon Valley, New York City, Los Angeles, and Boston.
First Republic grows by stealing the most valuable customers from larger banks by offering more attention and personalized service. The model works well, as First Republic can attract highly profitable clientele who keep $96,000, on average, in their personal bank accounts, nearly 2.5 times the average amount Americans held in all of their transaction accounts in 2016, according to the Federal Reserve.
Taking deposits and making loans to the wealthy enables First Republic to make high-quality loans that are less likely to default. Since 2002, the bank's loan losses peaked at 0.48% of loans in 2009, well below the 1.67% of loans the top 50 U.S. banks charged off that year. As of the end of the third quarter in 2018, nonperforming assets stood at just 0.04% of total assets.
More deposits per client relationship mean First Republic can spend heavily on customer service without threatening its bottom line. The bank's efficiency ratio, which teeters in the low 60% range, is impressive, given that it's constantly hiring more bankers to grow the business. Investing in new hires and new branches cost First Republic in the here and now for long-term gain; thus, its efficiency ratio overstates somewhat the expenses it would incur if it simply turned off the growth machine.
Since 2012, First Republic's deposits have grown at an impressive average annual clip of 19%, primarily by opening new offices and grabbing a greater share of ultra-wealthy customers in the markets in which it competes. Yet even today, less than 5% of millionaire households in its key geographies bank with First Republic, which gives it a lot of room for growth by stealing share from competitors.
4. BB&T: a slow and steady regional bank
If there's a place for an "old school" regional bank in your portfolio, BB&T would be a good choice. This slow-growing bank operates under the BB&T name in the Southeast United States, earning its money by taking deposits and making loans to individuals and to small and mid-sized businesses.
Its commercial franchise enables it to attract piles of low-cost deposits, as roughly one-third of deposits are non-interest-bearing. As a result, BB&T earned returns on assets in excess of 1% even during the banking doldrums of 2014 to 2016, when low interest rates weighed on bank profits. Since then, rising rates helped propel the bank's return on assets to 1.48% in the first nine months of 2018.
What separates BB&T from other banks is its conservative culture and its ability to get compensated for lending risks. Loan losses peaked shortly following the financial crisis, in 2010, when BB&T charged off 2.41% of loans, far more than some other lenders.
But though it may have charged off more loans than its similarly sized rivals did, BB&T wasn't taking undue risk in the years leading up to the financial crisis. Throughout the downturn, BB&T earned more in interest income than it set aside for bad loans, in contrast with many other regional banks, which had loan losses in excess of interest income. BB&T's loan portfolio may have been more risky than those at other banks, but it was adequately compensated for taking those risks. All banks take risk, but few manage to get paid for it the way BB&T does.
This bank is a natural acquirer that grows by buying smaller banks, rolling up their customers into its franchise before closing down branches, and eliminating duplicated expenses. Recent transactions have included other non-banking businesses such as insurance brokerages, which enable it to generate steady commission income that diversifies its income sources. In the first nine months of 2018, fee income made up roughly 42% of the bank's total revenue.
This is both a quintessential regional bank stock and an impressive commercial bank. It won't blow the doors off with double-digit annual growth in loans or deposits, but it is one of the few "sleep well at night" banks that plays close to the chest by putting loan quality above loan growth.
5. Wells Fargo: a fixer-upper big bank stock
Once one of the stock market's darlings, Wells Fargo has lost its luster in recent years. In 2016, its "fake account" scandals tarnished its image and cost it dearly in fines and reputational capital. In 2018, after several more scandals, regulators took the unprecedented step of capping Wells Fargo's size to $2 trillion in assets, halting its growth until it proves that its errors are behind it.
Though the headlines aren't friendly to Wells Fargo, it still has advantages that separate it from the pack. Often called "America's largest community bank," Wells Fargo is a big bank that looks nothing like its trillion-dollar peers because complex businesses, like investment banking, are a rounding error to its results. It makes most of its money taking deposits and making loans to individuals and small businesses, which insulates it from the large and unpredictable losses that have a way of popping up from Wall Street trading desks.
Its underwriting record is also worthy of envy. Many consider Wells Fargo a canary in the coal mine for its ability to spot and dodge the worst lending disasters. It never got involved in rampant subprime lending in the years leading up to the housing crisis, and it famously rejected the notion that it should take bailout funds to help hide the lending missteps of its rivals. In recent years, it pulled back from aggressive lending in car loans, worrying that lenders weren't being compensated for the risk.
Though the strict asset cap means Wells Fargo can't grow until it gets regulatory approval, it also means the bank is unlikely to take undue risk in its loan portfolio. Since it's limited to $2 trillion of assets, loan applicants are competing for a limited amount of space on its balance sheet.
The asset cap has also forced Wells Fargo to remove some bloat from its operations. Nearly a decade after the financial crisis, the bank is finally closing or selling less productive branches that other banks would have probably closed years ago. I expect that regulators will eventually allow Wells Fargo to grow again, but for now, the bank seems plenty happy to plow its earnings into buying back its stock at depressed prices, which could be a boon for long-term investors.