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Hallmarks of Success for Banks
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What should investors look for when investing in banks and other financiers? Because their entire business—their strengths and their opportunities—is built on risk, it's a good idea to focus on conservatively managed institutions that consistently deliver solid—but not knockout—profits. Here's a list of some major metrics to consider.

Strong Capital Base

A strong capital base is the number one issue to consider before investing in a lender. Investors can look at several metrics. The simplest is the equity-to- assets ratio; the higher, the better. It's difficult to give a rule of thumb because the level of capital should vary with each institution based on a number of factors including the riskiness of its loans, but most of the bigger banks we analyze have capital ratios in the 8 percent to 9 percent range. Also, look for a high level of loan loss reserves relative to nonperforming assets.

These ratios vary depending on the type of lending an institution does, as well as the point of the business cycle in which they are taken. All of these metrics are found in banks' financial reports, and they can be compared to in­dustry averages by logging on to the FDIC Web site, www.fdic.gov.

Return on Equity and Return on Assets

These metrics are the de facto standards for gauging bank profitability. Gen­erally, investors should look for banks that can consistently generate mid- to high-teen returns on equity. Ironically, investors should be concerned if a bank earns a level not only too far below this industry benchmark.

Given the size of the average bank's asset base relative to equity, it's not difficult to imagine a doomsday scenario. Earnings serve as the first layer of protection against credit losses. If losses in a given period exceed earnings, a reserve account on the bal­ance sheet serves as a second layer of protection. Banks must have a pool of reserves to protect shareholders, who hold only a small stake in the company because of the leverage employed.

If losses in a period exceed reserves, the difference comes directly from shareholders' equity. Equity is an accounting-based expression of a company's net worth, and it's criti­cal for banks. Go back to the basic balance sheet equation: Assets = Liabilities + Equity. Liquidate the company and equity represents anything that's left over. Eliminate equity, and the only party left with any claim on the assets is creditors. When losses at a bank start destroying equity, turn out the lights.

Leverage is easily expressed as a ratio: assets/equity. The average bank has a leverage ratio in the range of 12 to 1 or so, compared to 2 to 1 or 3 to 1 forthe average company. Leverage isn't evil. It can enhance returns, but there are inherent dangers. For example, if you buy a $100,000 home with $8,000 down, your equity is 8 percent. In other words, you're leveraged 12.5 to 1, which is pretty typical for a bank. Now, if something atypical happens and the value of your home suddenly drops to $90,000 (just 10 percent), your equity is gone. You still owe the lender $92,000, but the house isn't worth that much. You could walk away from the house $8,000 poorer and still owe $2,000. Highly leveraged businesses put themselves in a similar situation.

This doesn't mean all leverage is bad. As a rule, the more liquid a company's balance sheet, the more the company can be leveraged because its assets can be quickly converted to cash at a fair price.

After all, many fast-growing lenders have thrown off 30 percent or more ROEs just by provisioning too little for loan losses. Remember, it can be very easy to boost bank's earnings in the short term by underprovi- sioning or leveraging up the balance sheet, but this can be unduly risky over the long term. For this reason, it's good to see a high level of return on assets, as well. For banks, a top ROA would be in the 1.2 percent to 1.4 percent range.

Efficiency Ratios

The efficiency ratio measures noninterest expense, or operating costs, as a percentage of net revenues. Basically, it tells you how efficiently the bank is managed. Many good banks have efficiency ratios under 55 percent (lower is better). For comparison, the average efficiency ratio of all insured institutions in the fourth quarter of 2OO2 was 58.4 percent, according to the FDIC. Look for banks "with strong efficiency ratios as evidence that costs are being kept in check.

Net Interest Margins

Another simple measure to watch is net interest margin, which looks at net interest income as a percentage of average earning assets. Virtually all banks report net interest margins because it measures lending profitability. You'll see a wide variety of net interest margins depending on the type of lending a bank engages in, but most banks' margins fall into the 3 percent to 4 percent range. Track margins over time to get a feel for the trend—if margins are rising, check to see what's been happening "with interest rates. (Falling rates generally push up net interest margins.) In addition, examine the bank's loan categories to see "whether the bank has been moving into different lending areas. For example, credit card loans typically carry much higher interest rates than residential mortgages, but credit card lending is also riskier than lending money secured by a house.

Strong Revenues

Historically, many of the best-performing bank investments have been those that have proven capable of above-average revenue growth. Wide margins have generally been elusive in a commodity industry that competes on service quality. But, some of the most successful banks have been able to cross-sell new ser­vices, which adds to fee income, or pay a slightly lower rate on deposits and charge a slightly higher rate on loans.

Keep an eye on three major metrics: (1) net interest margin, (2) fee income as a percent of total revenues, and (3) fee income growth. The net interest margin can vary widely depending on economic factors, the interest rate environment, and the type of business the lender focuses on, so it's best to compare the bank you're interested in to other similar institutions. Fee income made up 42 percent of bank industry revenue in 2001 and has grown at an 11.6 percent compound annual rate over the past two decades. A large and diversified company such as Fifth Third generates more than 40 percent of its net revenues from fee income, whereas smaller, less diversified companies such as thrifts (e.g., Golden West) get just 10 percent to 12 percent of income from fees. Make sure, therefore, that you're comparing similar companies and that you understand the company's strategy. As always, examine the number over a period of time to get a sense of the trend.

Price-to-Book

Because banks' balance sheets consist mostly of financial assets with varying degrees of liquidity, book value is a good proxy for the value of a banking stock. Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value. For any premium above that, investors are paying for future growth and excess earnings. Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed. Typically, big banks have traded in the two or three times book range over the past decade; regionals have often traded for less than that.

A solid bank trading at less than two times book value is often worth a closer look. Remember, there is almost always a reason the bank is selling at a discount, so be sure you understand the risks. On the other hand, some banks are worth three times book value or more, but we would exercise cau­tion before paying that much. Bank stocks are volatile creatures, and you can find good values if you're patient—especially because even the best banks will generally be hit hard "when any high-profile blowup occurs in the financial services sector. Lining up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.

These metrics should serve as a starting point for seeking out quality bank stocks. Overall, we think the best defense for investors who want to pick their own financial services stocks is patience and a healthy sense of skepticism. Build a paper portfolio of core companies that look promising and learn the businesses over time. Get a feel for the kind of lending they do, the way that risk is managed, the quality of management, and the amount of equity capital the bank holds. When an opportunity presents itself—and one always does— you'll be in a much better position to act.

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