Banks are the foundation of just about every modern economy. These companies offer a variety of services that are integral to business owners, employees, corporations, and much more. Every business intends to make money, but banks are in the business of making money. Investors love bank stocks because they have stable business models and tons of free cash flow, but the biggest banks stocks aren’t always the best.
How Do The Best Banks Make Money?
Banks have various means of collecting revenues, but some banks only focus on certain types of financial services. Some banks focus on consumers, and others cater to corporate clients. Other banks specialize in a narrow range of select financial services. Despite their differences, banks share common means of generating revenues.
Anyone who’s ever had a checking account will tell you, banks charge fees for everything. Overdraft fees, non-sufficient funds fees, balance transfer fees, ATM fees, card fees; the list goes on and on. Banks generate some of their revenues with service fees but, proportionately, fees only make up a small portion of total bank revenues.
Banks have tons of cash, but the majority of it isn’t just sitting around. One way banks put their cash to use is by making loans and buying bonds. The money banks collect from the interest earns on loans is interest revenues. Banks earn interested revenues on a variety of different financial products, and they receive regular payments from their bond holdings.
Ideally, investments should increase in value over time. Banks trade stocks, invest in real estate, fund businesses, and make a variety of other investments. When these assets increase in value, the bank profits on its investment. When the assets are sold for profit, the profits are recorded as capital gains.
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Mega-Cap Bank Stocks
These banks are the largest banks in the U.S. and they’re in a class all their own. They’ve got mountains of cash and invest billions of dollars every year.
JP Morgan Chase & Co (NYSE: JPM)
One of America’s oldest – and largest – banks, JP Morgan Chase is a global financial powerhouse. Chase has its fingers in practically every corner of the finance sector, and it also has a robust consumer banking division. It’s arguably the most powerful bank in the United States and possibly the world. The bank’s enormous scale gives it a tremendous advantage over many of its smaller competitors, and its management team has been the best in the business for decades.
JPM earns revenues from a wide variety of financial services, including investment banking, credit cards, and underwriting. Few banks can match JPM’s consistently excellent performance over the past couple of decades. The executives at Chase always seem to be at the right place, making the right moves, at the right time.
Bank Of America (NYSE: BAC)
One of Stock-Picker Extraordinaire Warren Buffet’s largest holdings, Bank of America is another leading U.S. bank. Consumer banking is Bank of America’s bread and butter. It’s one of the leading retail banks in the U.S. and it also offers wealth management services on a nationwide scale. However, its 2008 acquisition of Merrill Lynch spearheaded the firm’s expansion into investment banking over the last decade.
Bank of America was a bit of a mess a few years earlier, but it’s turned a corner as of late. Its acquisition of Merrill Lynch and Countrywide Financial created a lot of headaches for shareholders, and the bank spent billions cleaning up a mess of legal and regulatory issues that resulted from the deals. However, CEO Brian Moynihan has done an excellent job of trimming the fat and making the bank more efficient. Management is making much better capital allocation decisions and the improvements have contributed to the bank’s long-awaited turnaround.
Citigroup Inc. (NYSE: C)
Citi is the smallest bank out of the Big 4, but it’s still a major player with a market cap of over $160 billion. The bank has become much more disciplined over the past few years, and its operational efficiency improved drastically as a result. The bank spent the last few years transforming itself into a leaner, meaner company but it’s finally shifting to a more offensive game plan. Management is waging a multi-front campaign to increase capital returns, cut costs, and build shareholder value.
Citigroup’s huge presence in emerging markets gives the firm a unique advantage over its competitors. It has extensive capital investments in Asia, Latin America, and other emerging markets. These holdings could pay off big over the next few years, especially since U.S. economic growth is slowing to a more modest pace. Global growth is currently in the midst of a downturn, but that could change rapidly. If higher growth returns to emerging markets, Citi could be reaping big returns.
Not every bank is a gigantic multinational corporation. Some smaller banks focus on a specific geographical region of the country. These banks are commonly referred to in the industry is regional banks, but many of them have branches across the U.S. so the term is a bit of a misnomer. They aren’t established as the big boys, but smaller regional banks have more room to grow. Since regional banks tend to have more potential for growth, they often trade at higher price-to-earnings multiples than their big brothers.
First Republic Bank (FRC)
First Republic is a consumer-focused bank with operations across the U.S. This is a good example of a regional bank that’s valued at a much higher multiple than its peers. The U.S. consumer is historically strong, so that might be one reason that this mid-cap bank is valued so highly. Its emphasis on private banking means it has excellent exposure to consumer trends, so its growth outlook is strong. However, a high valuation also means that this bank stop has a lot of room to fall if sentiment takes a downturn.
Citizens Community Bancorp (CZWI)
This bank stock had a rough year, but it looks like it might be ready for a rebound. Analysts are mostly bullish on this micro-cap bank stock. Citizens Community Bancorp is a regional bank in the truest sense of the term, it provides various consumer, commercial, and agricultural banking products to clients in Wisconsin, Minnesota, and Michigan. The bank operates 27 full-service branches across the region, and it’s based in Eau Claire, Wisconsin.
The newest wave in the banking sector is all-digital, mobile banking. These companies don’t have any physical branches, but they usually offer customers enhanced convenience and value to compensate for their lack of a brick-and-mortar presence.
Ally Financial Inc. (NASDAQ: ALLY)
Ally is one of the pioneers of the digital banking industry. This bank has no branches, it delivers all services to customers digitally. Users have the same options they would at a traditional bank, but they have to do interact with their accounts electronically. Not having a physical branch might sound inconvenient, but digital banks usually offer low fees and significant incentives for customers to make the switch.
Ally is widely considered to have excellent customer service. Plus, bank customers are getting more comfortable with the idea of an all-digital bank. This digital bank stock has been a solid performer over the past year and it might be worth watching.
Characteristics Of The Best Bank Stocks
Bank stocks tend to be conservative, value-oriented investments. Many banks, the Big 4 especially, are valued so highly that it’s hard for them to move the growth needle. To compensate for lower growth potential, most banks pay regular dividends to shareholders.
Some statistics are more important with banks than they are with other companies. Return on equity and return on capital are particularly important ratios for banks. Those statistics are basically the primary benchmarks by which banks gauge their efficiency. However, PE and other earnings-related statistics also carry weight.
What Moves Bank Stocks
Bank stocks are very intertwined with the overall market. These companies play an important role in the economy, so they can be influenced by a variety of factors. Housing, interest rates, and job data are just a few examples of events that can move bank stocks. This sector is like a sentiment gauge for the U.S. economy. If the outlook for the economy is high, bank stocks tend to do well but, in times of distress, bank stocks often perform poorly.
Bank ETFs: The Easy Way to Bet on Banks
ETFs make it easy for an investor to gain exposure to certain sectors of the market. For example, the Financial Select Sector SPDR ETF (NYSE: XLF) invests in a basket of bank stocks.
Some of its largest holdings include JP Morgan Chase, Bank of America, Wells Fargo, and Citigroup. It also invests in other financial companies like Goldman Sachs and Berkshire Hathaway.
Bank ETFs offer traders diversified exposure to the financial sector, and they have very low barriers to entry. They trade just like stocks so it’s easy for traders to allocate funds to diversified financial holdings without overhauling their portfolios.
The Outlook for the Banking Industry
After researching this topic, I have come to a few key conclusions.
- If we go into a recession in the next year, the banks could take a hit. The Fed would likely lower interest rates again and market sentiment towards the banking sector will likely exaggerate any sector-wide downside moves.
- Consumer-oriented banks could be the biggest beneficiary of increasing business and mortgage lending. During last quarter’s earnings season, Main Street banks, like Wells Fargo and Bank of America, seemed to fare better than Wall Street banks, like Goldman Sachs and State Street.
- If these stocks are undervalued, there is no guarantee that they will return to the previous valuations anytime soon. It could be years before we start to see P/Es over 20 in the banking sector. If a recession comes along, things could get worse before they get better.
If you’re investing for the long-term, banks could be a strong buy right now. From a valuation perspective, the sector looks very attractive, but there’s no way to tell how long it will take P/E’s to revert to average. There’s no clear catalyst on the horizon for banks, so it could be a long, twisted road back to average valuations.
Consumer-oriented banks with strong management and cheap valuations could be a good buy for long-term investors. However, traders should beware that a short-term slowdown in the economy could hurt this group.
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