7 Small Banks That One-Up Wells Fargo

At the Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) annual meeting, Warren Buffett dropped a bomb when he said that he would have gone all-in on Wells Fargo (NYSE:WFC) at the March lows. That certainly got my attention and prompted me to ponder what makes for a killer banking franchise.

Every bank will eagerly tell you how special it is, pointing to everything from its conservative lending standards to its superior customer service. Sometimes, these claims happen to be true. But in my eyes, banking is a fairly commoditized business. If that's the case, then what works for folks like EOG Resources (NYSE:EOG) in the oil patch, Wal-Mart (NYSE:WMT) in retail, or GEICO in the auto insurance realm ought to work in the banking business as well.

In other words, the low-cost producer wins. That's exactly the status that Wells Fargo boasts among the big banks, with rock-bottom borrowing costs of 2.25% last year. Wells' ability to source low-cost deposits contributes directly to a fat net interest margin and indirectly to some historically strong returns on equity.

Going on a bank safari
Even back in 1990, the first time Buffett wrote about Wells Fargo in one of his annual letters, the bank was already quite large, with $56 billion in assets. So, this big bank was already a great fit for Buffett, who needs to bag elephants in order to move the earnings needle at Berkshire. The rest of us are free to hunt for smaller game, however, and that's exactly how you'll find banks that sport both lower borrowing costs and higher net interest margins than Wells.

In fact, a recent search along these lines turned up exclusively small cap banks, with none exceeding $2 billion in market capitalization. Here are the seven largest:

Figures are for calendar year 2008. Data provided by Capital IQ.

To be clear, no single metric makes a stock a must-buy. Just as an oil and gas company could have low finding costs but a poor liquidity position, any of the above banks could have made some bone-headed lending decisions over the last few years that would totally negate the competitive advantage bestowed by these low borrowing costs. Buffett likes Wells not only for its cost of funds, but for the way it adroitly deploys those funds. The firm's robust non-interest income isn't captured in the funding cost metric, either.

Here's an example of where an exclusive focus on borrowing costs could cost you dearly. Capital City has seen its non-performing assets (NPAs) run up to 6.4% of loans and other real estate, triple the percentage reported just a year ago. The company believes itself to be "dedicating sufficient resources and talent to understand, monitor, and eventually resolve" its red-headed stepchild loans. Whether the firm ignored the risks to its loan book, or flat-out failed to perceive them (as seems to be the implication here), neither is a very satisfactory state of affairs. The shares have been cut in half this year.

Despite the potential pitfalls, there are some promising bank stocks elsewhere on this list.

Minting money in Marin
Both of the Marin County, Ca.-based banks look pretty attractive to me. Westamerica, for one, has a record of extraordinarily tight non-interest expense control. The firm's efficiency ratio weakened in 2008, but that was solely as a result of falling revenues rather than any cost creep. This bank sports the highest pre-tax earnings margin out of the bunch. My biggest complaint would probably center on Westamerica's slow loan growth, but acquisitions of failed competitors like County Bank ought to help with that. Bank of Marin, meanwhile, has been growing at a nice clip, and it is the only bank on the list that's compounded its book value faster than Wells over the past seven years. Bank of Marin also sports the second-highest pre-tax margin.

Over the counter, overlooked
A few of the other banks on the list are traded over-the-counter and are extremely illiquid (i.e., less than $200,000 worth of daily trading volume), so I'll leave the exploration of those names to my more intrepid readers. I will say that Tri City, a Milwaukee-area community banker, is notable for its crystal-clear financials and its founding family's big ownership stake, if you go for that sort of thing.

More Foolishness:

• Is It Time to Buy Banks?
• Roundtable: The Stock to Sell Now
• Banks Are Getting a Great Deal at Our Expense!