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Investing in Bank Stocks: What You Need to Know

Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel look at third-quarter 2017 bank earnings and discuss industry trends, as well as highlights from each bank. In addition, we discuss some of the most important metrics investors should use to evaluate bank stocks, and we share our personal favorites.

A full transcript follows the video.

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This video was recorded on Oct. 23, 2017.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Oct. 23, and we're talking big bank earnings and investing today. I'm your host, Michael Douglass, and I'm joined by Matt Frankel, who's currently at the Money20/20 conference in Las Vegas. Matt, you look a little tired today. Long weekend in Vegas?

Matt Frankel: I'm going to blame that on the time change. Let's go with that.

Douglass: Sure, that seems like a reasonable thing to claim. Before we get started, I wanted to give a quick shout-out to our listeners and a thank-you for listening through Pitch Week. A lot of people wrote in wanting to learn more about Mastercard, Square, and Berkshire, proving that Financials isn't quite as boring as a lot of people seem to assume.

Before we get into things, I wanted to highlight something. We heard 15 stock pitches last week. Maybe you missed an episode, or maybe you just didn't get them all written down. E-mail us at industryfocus@fool.com, and we'll happily send you the list of all 15 stocks that we discussed and their tickers. Again, that's industryfocus@fool.com.

With that, let's talk about big bank earnings. That's, for those who are keeping score at home, Morgan Stanley (NYSE: MS) and Goldman Sachs (NYSE: GS), Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB), and Bank of America (NYSE: BAC), Citigroup (NYSE: C) and JPMorgan (NYSE: JPM). Generally speaking, most everyone did well, except for Wells Fargo, but we'll get into that. Let's start with some generalities, and then we can get into some specifics about each. One of the first things that really I saw was, trading revenue was a lot lower pretty much across the board.

Frankel: Yeah, that tends to happen in low-volatility environments like this. The prices are moving around a lot less, so people tend to trade a lot less. That's kind of a negative thing, with volatility being at historic lows right now.

Douglass: Sure. I guess this is the drawback of stocks doing so well so far this year. On the flip side of that, a good thing for the banks, I noticed a lot of cost cuts. They're reducing branches. They're also cutting staff. And that's helping them better control their expenses.

Frankel: Definitely. In Bank of America's case, they closed 113 or 114 branches this past quarter alone. This is why you see revenues up across the board, but earnings are up even more, and the big reason for that is, costs are going down.

Douglass: Absolutely. On the flip side, one other issue. It's a slight concern. You're seeing some bumps in delinquencies and defaults, particularly credit card charge-offs. That's something we'll want to monitor going forward.

Frankel: Yeah. You're not anywhere near the danger zone just yet. But a lot of experts are saying that credit card debt is at a record high level, even from before the financial crisis, and this is something to keep an eye on, that people are maybe buying a little too much and we can see an uptick in defaults.

Douglass: Right. Let's turn to specifics about the banks. Of course, Matt, you're a talker, I'm a talker -- we're going to need to get through this pretty quickly just so we don't bog down the entire episode. Let's just take a minute to look at each of these big banks, and how they got to their win or, in Wells Fargo's case, loss, compared to analysts' expectations. Starting with Morgan Stanley, wealth-management business seems to be doing really well. They have $2.3 trillion in assets under management. Lots of opportunity there in cross-selling other products to wealth-management clients. Think mortgages and other kinds of loans to further enhance the bank's profitability. I think they have a lot of really interesting opportunity from here.

Frankel: They do. Both big investment banks have a lot of big opportunities, especially as they start to branch out into more traditional banking areas.

Douglass: One of the interesting trends that you'll see with banks right now is -- there is a lot of this -- you have your traditional investment banks. That's Morgan Stanley and Goldman Sachs. And they're kind of hopping into a lot of things that have not traditionally been in their purview. And you're seeing this in a lot of banks. There's this attempt to cross-sell and be a one-stop shop across the board for people and businesses in different stages. Certainly, with Goldman Sachs, they had a lot merger-and-acquisition fees. That's the other investment bank, by the way.

Frankel: Yeah, Goldman Sachs actually has the No. 1 market share in mergers and acquisitions. And IPOs, for that matter.

Douglass: Right. It's interesting. They are really focusing a lot of effort on consumer lending right now, with their Marcus online lending platform. I don't know about the rest of you, or you, Matt, but I get a lot of Marcus Loans advertisements on Facebook, so I'm certainly hyper-aware of that particular attempt by them.

Frankel: And it's been successful so far. They hit $1 billion in loans quicker than Lending Club or pretty much any of the other big players. And they have a big advantage in that they have tons of capital to lend. They don't have to wait for investors to put up money. They can grow it as quickly as possible.

Douglass: And speaking of having lots of capital, the Fed cleared them to raise their dividend next year. So that's good news for Goldman Sachs shareholders as well.

Let's hop on over to the commercial banks. Wells Fargo -- that's going to be the headline here. Not a great quarter by really just about any measure.

Frankel: Right. Like you said, revenue was pretty much up across the board except for Wells Fargo. Interest margins were up across the board except for Wells Fargo. Efficiency was up across the board except for Wells Fargo. I could keep going with that. But it was just all over the place. It was tough to find things to be happy about in this quarter for Wells Fargo.

Douglass: In a lot of ways, Wells Fargo is still struggling from the fake-accounts scandal last year and any number of other investigations and negotiations with the federal government over practices of various sorts. This is a lot to dig into there, more than we can in this episode. But a lot of concerns for Wells Fargo. I think that's reflected in relatively poor stock performance. 

Frankel: One thing to point out with Wells Fargo, if you don't mind, is a lot of the negative results this quarter were also partly attributed to legal costs. It's not just their business that's suffering. It's, they're being hit with all kinds of fees and fines, and there's really no telling if there's going to be more at this point.

Douglass: Yeah. So a lot of uncertainty there right now. Let's turn to U.S. Bancorp.

Frankel: Sure. U.S. Bancorp is historically one of the most profitable banks in the country, especially for its size. And actually, for the past few years, it's been Wells Fargo, U.S. Bancorp, and then everyone else. Now it's just U.S. Bancorp and everybody else. Their return on equity, return on assets, which we're going to get into in a minute, is way above everybody else's. Same could be said for efficiency. Well, it's lower than everyone else's, but it's much better.

Douglass: Just across the board, when you look at the metrics, U.S. Bancorp looks like it's in a pretty darn strong spot. Let's turn to the universal banks. These are your traditional banks that really have been involved in a lot of different areas. They've had, if you will, their fingers in a lot of different pies. Let's start with Bank of America. Good news for Bank of America shareholders in that they've really done a good job of expense management. Their efficiency ratio is now down to just below 60%, which is a massive improvement from the Bank of America of the past.

Frankel: They're getting more efficient, not just because they're reducing their physical footprint. They're really doing a good job of pushing mobile and online banking. Mobile especially. A check deposit costs the bank something like one-tenth of what a deposit in a branch costed. So the more people they can get to use their online tools, their peer-to-peer payment solutions and stuff like that that are really starting to take off, the better off they'll be. And it's still a pretty small percentage of their transactions that are being done through mobile.

Douglass: Yeah, so there's a lot of opportunity to continue mitigating costs going forward with all these upfront investments they've made in technology.

Frankel: Yeah. They've probably done, in my opinion, the best job of the big banks in really leveraging their online platform.

Douglass: Sure. Let's turn over to Citigroup. With Citigroup, two important things to point out. Efficiency ratio is down to 56%, which is sort of unheard of in the old Citigroup. So that's really good news, to see that they're doing a good job of expense management. And on the flip side, credit cards are showing more charge-offs. And that's, I think again, something that we're going to need to watch moving forward.

Frankel: Yeah. Citigroup is the only one of the big banks with a long way to go before their profitability is where it needs to be. They still have a relatively low return on equity for their shareholders.

Douglass: Yeah. And finally, JPMorgan. So one of the interesting things about JPMorgan is, JP Morgan Chase, the Chase Sapphire Reserve card is beloved among credit card hackers. And management reports that it's finally starting to pay off for the bank. So this is a credit card with a lot of perks, and they're finally able to, they're attracting the sort of people they want to with those perks, and then are able to make money in other ways off that credit card. So that's good news.

Frankel: Yeah. Credit cards in general -- the Sapphire card was not very profitable at first, because they were pretty much giving away a sign on-bonus worth about $1,000. So it took them a long time before that was recouped by the increased business. But it looks like it's finally starting to pay off. A lot of people in the industry thought they were crazy for giving away, I think it was 100,000 frequent-flyer miles at first, something like that.

Douglass: Something like that, yeah. So it's good to see that working out. And wealth management is also paying off well for them, too, so that's good news.

Frankel: Definitely. They're doing a great job all around. There's really nothing negative to say about JPMorgan over the past few years.

Douglass: Absolutely. Let's go back now to the overall sector. There are a few catalysts for banks moving forward that investors should be aware of. First off, interest-rate increases.

Frankel: Yeah. Generally, when interest rates go up, the banks profit. They call it net interest margin. The bank's profit margin expands. That's the difference between what a bank can make on its loans and what it's paying for deposits and things like that. So as the Federal Reserve is expected to increase interest rates at least a handful of times over the next few years, this should also increase bank profits.

Douglass: Yeah. Their ability to pocket that bigger spread between what they're paying for deposits and what they're getting for loans will be, hopefully, a big driver for the bank's underlying businesses in a higher-interest-rate environment. Secondly, let's also talk about deregulation. This is something we've talked about in several Industry Focus: Financials episodes. Frankly, the banking sector is very interested in there being some deregulation so that they can find different ways to leverage that money for better profitability.

Frankel: That's especially true in these big banks, once they're above that $50 billion asset threshold, which everything we've talked about is. Then the regulations just jump to another level.

Douglass: Right. We'll talk more about how to think about big banks in a minute. By that, what I mean is, unpacking some of those ratios we talked about and really thinking about how to identify a moat, and frankly, whether any of them is a compelling investment today.

So before we hop into bank metrics, I just want to point out, this is going to be a very high-level look at them. If you really want to understand how to invest in banks, we have a great article that breaks down how to understand a bank piece by piece. When I took over our financial coverage in 2014, it was my Bible, and really still is today. Send us an email at industryfocus@fool.com, and I will be happy to share it with you. Again, that's industryfocus@fool.com.

Let's talk about investing in big banks. I think the first thing we should talk about is, at their core, banks taking money as deposits and then lending that money out as loans. So you want to know, frankly, whether they're good at lending that money to people who aren't going to default on the loan, which would impact their profitability very negatively. One of the ways you can measure that is with the net charge-off-to-loan ratio, which is what percentage of loans are so delinquent and so unrecoverable that the bank thinks it won't get its money back. So lower is, of course, better. Other thoughts on that, Matt?

Frankel: To follow up on what you just said, this is why Citigroup and Bank of America crashed after the financial crisis, while U.S. Bancorp never even had a quarter where they were in the red. Their defaults, they ticked up, but it was never to the point where they were losing money. This is what you were talking about with, they're much better at figuring out who they should lend money to.

Douglass: And actually, you've made a point that I want to draw out a little bit more, which is, when the economy tanks, those numbers are going to increase. There are going to be more people who become delinquent, whether you're a great lender or a really bad lender. But one of the things to keep in mind is, look at each lender in comparison to the others. If you have one that has a much lower net charge-off-to-loan ratio versus another, that's a good sign for that company. And that's just something to keep in mind. The absolute numbers matter, but a rising or sinking tide will affect all the boats. So you want to keep that in mind and compare them to each other.

Let's talk about expense management a little bit.

Frankel: Sure. This is where a metric called the efficiency ratio comes into play. It's actually really easy to calculate. Take the bank's non-interest expense and divide by the total revenue it generates. It's basically how much a bank is paying in order to generate its revenue. Lower is better. Generally, 60% or so is what you're looking for for a big bank. About half of the banks we talked about are lower than that; about half of them are higher than that. But that's kind of the benchmark for a big bank.

Douglass: Right. And U.S. Bancorp, to give it a shout out, has the lowest efficiency ratio of that bunch at 54.3%.

Frankel: JPMorgan is actually in a close second, and surprisingly, Citigroup is up there, too.

Douglass: Right, it's interesting. Again, this is not what you would historically expect, given the history of the banking industry. But it's a new day, and new things are happening.

Let's talk about bank profitability as well. That's return on assets and return on equity. Looking at both of those, that's how you can understand how well the bank takes that hopefully low credit risk and makes money off it.

Frankel: The two benchmarks you want to look at are 1% return on assets and a 10% return on equity. Return on assets is a measure of how well a bank takes all of the money it has and uses that to make more money. Return on equity is how well it's using the money shareholders have invested to turn a profit.

Douglass: Exactly. And let's also talk a little bit about what happens if everything bad hits the fan. There are a ton of different ratios that you can use to try to stress-test a bank a little bit. Of course, the banks actually go through stress tests with the Federal Reserve. But one that's pretty commonly used is the tier 1 common capital ratio. It's reported on by every big bank, and it basically measures how much strain they can take before really bad things start happening. So the higher the ratio, the better.

Frankel: Right. At this time, all of the banks are well above the regulatory threshold. I think most of them are probably double the regulatory threshold at this point. This just kind of tells you, under a worst-case scenario, which, I think the stress-test worst-case scenario is something that's even worse than the financial crisis was, something like 10% unemployment, things like that, and how well a bank would hold up before it would start losing money or need a bailout like they did during the financial crisis. Again, this is another metric you compare with other banks and take with a grain of salt at this point, because everything is going well.

Banks have really recapitalized because regulations are high. This is another thing to keep an eye on, if regulations get rolled back. Right now, it's actually looking pretty good across the board. I think the highest capital ratio is Morgan Stanley at this point, and Goldman Sachs. Both investment banks have really high capital. Among the other banks, Citigroup surprisingly is the top, with a 30% tier 1 capital ratio.

Douglass: Right. And of course, when thinking about each of these metrics, the next question is, of course, OK, cool, that's what you're getting, but what are you paying for that? And there are a lot of different valuation metrics out there. The one that I prefer for banks is price to tangible book value. Book value is essentially what the business' assets are worth. That includes intangible assets and goodwill, which, frankly, those are hard to value. So I tend to prefer tangible book value because it's, well, tangible assets, so it's easier to get a precise valuation for, and then price over that basically gives you a sense as to what that valuation looks like -- again, in comparison to other banks.

Frankel: And this is a good one to use in conjunction with the return on assets, return on equity, and efficiency ratio we were talking about. You want to know how much you're paying for a bank, given its profitability. For example, U.S. Bank trades at by far, by far, by far the highest price-to-tangible book value. Just to kind of give you a reference without telling you too much, going too much into the numbers, they're about 3 times tangible book value right now. For comparison, JPMorgan is a distant second at 1.8 times book value. The industry average is between 1.3 and 1.5 times book value. So U.S. Bank is by far the most profitable of the big banks, but you pay for it.

Douglass: Right. So that's one of the things you have to weigh when you're engaging in an investment thesis about these companies.

Let's turn to thinking about a moat. When you've got a big sector like this, and a bunch of different players that frankly are a little bit inscrutable, how does an investor identify a moat for them, and really figure out which one to invest in?

Frankel: That's a really good question. The moat, you can identify basically by something that differentiates the banks from the others and that should keep it going no matter what the market or the economy is doing. U.S. Bancorp is the obvious example, just because they're always profitable, have very few loan losses. The recent stress tests actually found that U.S. Bank would not only survive, but they would make money even in an absolute worst-case scenario. That's a pretty nice moat. That's a good margin of safety to have, too.

Douglass: Yeah, absolutely. I tend to agree. I think one of the other things to keep in mind is management. When you go back to a lot of these metrics that we've talked about, what they really come down to basically is, how smart is management at deploying capital, and how much risk are they taking on by doing so? And the more that you can read about management, hear what they say, hear how they talk about their business, I think the more you can understand a little bit, when you combine it with these metrics, what their credit risk looks like and how they think about investing in the company.

Keep in mind, every bank is going to say they are a conservative lender that's really careful about how it lends out money. That's just sort of par for the course for them to claim that. The reality, though, is going to be that when you combine these different ratios with what management is talking about and really try to better understand how they do this and what risk they're taking on by doing it.

Frankel: Definitely, just to see who's putting their money where their mouth is, I guess, is the best way to sum it up.

Douglass: Exactly. And one more time, as I mentioned earlier, my favorite article on banks is written by Anand Chokkavelu, who's a CFA at fool.com. Drop us a note, industryfocus@fool.com, and I'll be happy to send you that article, which really breaks down how to think about investing in banks.

Frankel: I actually learned a lot of what I know about things from that article.

Douglass: Yes, me too. Let's go ahead and take a step back. We've talked about big banks, we've talked about their news, we've talked about what's going on, we've talked about how to analyze them. Well, are there any that are actually worth investing in today?

Frankel: As a general statement, I think the potential catalysts we discussed are priced in at this point. Bank stocks, a lot of them have doubled in the past year or two, Bank of America being one. That's my personal biggest stock holding, Bank of America. But I don't know I would buy more today at the current price.

I personally like Wells Fargo, if you have a long time frame to let the drama play out. They're still a pretty expensive bank relative to the industry, but not compared to what their business was valued at before the scandal started. So if they're successful in recovering from the scandal over time, this current price could look pretty cheap.

And U.S. Bank is always a good long-term investment. You really can't go wrong with that one at any point.

Douglass: It's expensive, and for a reason.

When I think about Wells Fargo, my general thing is, I think the key question that you need to ask before you choose to invest in Wells Fargo is, this bank really did well on a lot of metrics for a very long time, in part because they did an aggressive cross-selling culture. Can they retain that aggressive culture? Can they in some way effectively cross-sell their products and grow their revenue and their underlying earnings without these negative externalities that often come with that, which is, people trying to cheat the system, creating fake accounts, things like that?

If the answer to that is yes, then Wells Fargo is undoubtedly cheap compared to where it used to be. It's still reasonably priced by most bank stock standards. But if you're concerned about that possibility, I think Wells Fargo is a stay-away.

Personally, I don't have enough data points, so I'm staying on the sidelines. I actually don't own any of the big banks. I'm only invested in a small bank right now. But I'm going to be keeping an eye particularly on the turnaround at Bank of America, because I think that's a very interesting story.

Listeners, that's it for this week's Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, 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. This show is produced by Austin Morgan. Thanks to Matt Frankel for joining us today. For Matt Frankel, I'm Michael Douglass. Thanks for listening, and Fool on!

Matthew Frankel owns shares of Bank of America, Berkshire Hathaway (B shares), and Square. Michael Douglass owns shares of Berkshire Hathaway (B shares), Facebook, and Mastercard. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares), Facebook, and Mastercard. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy.