Investing in Bank Stocks

Banks can seem like complicated businesses. They are complicated, in many ways. But the basic ideas behind the banking industry and how these businesses make their money are easy to understand. With that in mind, here's an overview of the different types of banks, some important metrics investors should know, and three great beginner-friendly bank stocks to keep on your radar.

The three categories of banking businesses

• Commercial banks: These are banks that provide services to consumers and businesses, including checking and savings accounts, auto loans, mortgages, and certificates of deposit. Commercial banks primarily make money by borrowing it at a relatively low interest rate and lending it to customers at a higher rate. Although commercial banks make the bulk of their money from interest income, many also collect substantial revenue from loan origination fees, ATM surcharges, and account maintenance fees. It's important for investors to note that commercial banking is a cyclical business. When recessions (and pandemics) hit, unemployment rises, and consumers and businesses often have trouble paying their bills.
• Investment banks: These banks provide investment services for institutional clients and high-net-worth individuals. Investment banks earn fees by issuing debt securities, offering advice on mergers and acquisitions, and helping other companies go public through IPOs. Investment banks also make money from trading in equities, fixed-income securities, currencies, and commodities. They typically have wealth management businesses and often have substantial investment portfolios of their own. Unlike commercial banking, investment banking tends to hold up quite well during recessions. When markets get volatile, investment banking often does better.
• Universal banks: A universal bank is one that has both commercial and investment banking operations. Most large U.S. banks are universal banks. Although commercial banks get the bulk of their profits from interest income and investment banks primarily rely on fee income, universal banks enjoy a nice combination of the two.

These are obviously simplified definitions. Banks have many other ways to generate revenue. For example, many banks offer safe deposit boxes for lease to their customers, and some make money through partnerships with third-party companies. However, at their core, these are the main ways that banks make their money.

Three top bank stocks to put on your radar in 2023

Hundreds of banks trade on the major U.S. exchanges, and they come in various sizes, geographic locations, and focuses. Although there are some excellent choices for investors, here are three beginner-friendly bank stocks that could deliver excellent returns for years to come:

1. Bank of America

Bank of America has been one of the most impressive turnaround stories in the post-financial crisis era. In recent years, the bank increased its loan portfolio at rates well ahead of its peers, and the company has made major improvements in efficiency while building out its online and mobile technology.

Bank of America's asset quality also is excellent, and with a relatively high concentration of deposits that don't pay interest, the bank is in a strong position to benefit from rising interest rates in the current Federal Reserve Board rate hike cycle. We're already seeing this reflected in the bank's net interest income. At the end of 2022, management estimated that a single percentage-point shift in the yield curve should translate to $3.8 billion in additional interest income per year.

Bank of America isn't completely immune to economic headwinds. If loan delinquencies spike higher, it could certainly come under pressure. However, it is in a strong position to weather most storms with a combination of an excellent retail banking operation and an investment bank that can benefit from market volatility.

2. JPMorgan Chase

JPMorgan Chase is hands-down the most profitable of the big U.S. banks, and it’s also the largest bank by market capitalization in the U.S. The bank has operations in just about every area of both commercial and investment banking, and it has done a particularly good job of expanding its credit card and auto loan businesses in recent years. JPMorgan Chase has also done an excellent job of embracing new technologies, and it has made some key investments in financial technology (fintech) companies.

Although the company's Chase consumer banking operation is one of the largest in the U.S., it is worth noting that JPMorgan Chase has the largest investment banking operation of the companies discussed here. This can be a positive catalyst in turbulent economies since activities such as trading tend to perform strongly in volatile markets, as we've seen during both the financial crisis and the onset of the COVID-19 pandemic.

3. U.S. Bancorp

U.S. Bancorp is primarily a commercial bank, with income from loans and other consumer banking products making up virtually all of its revenue. Not only is U.S. Bancorp (known to most Americans as U.S. Bank) focused on consumer banking, it consistently produces some of the most impressive profitability and efficiency metrics in the sector and has been an excellent dividend stock for investors.

Because it doesn't depend on investment banking, which is generally the more volatile side of the banking business, U.S. Bancorp's profitability and revenue tend to be more predictable and consistent than the other two banks on this list. However, while it is largely dependent on interest income, don't worry too much about U.S. Bancorp's ability to make it through the tough times unscathed. It was one of the only major banks in the country to remain profitable throughout the financial crisis and has an excellent history of smart risk management.

Important metrics for bank stock investors

If you're looking to invest in individual bank stocks, here are a few metrics that you might want to add to your tool kit:

• Price-to-book (P/B) value: An excellent valuation metric to use with bank stocks, the price-to-book, or P/B, ratio shows how much a bank is trading for relative to the net value of its assets. It can be used in combination with profitability metrics (discussed next) to provide a picture of how cheap or expensive a bank stock is.
• Return on equity (ROE): The first of two common profitability metrics used with bank stocks, return on equity is a bank’s profits expressed as a percentage of its shareholders’ equity. Higher is better; 10% or above is generally considered strong.
• Return on assets (ROA): This is a bank’s profit as a percentage of the assets on its balance sheet. For example, if a bank made a $1 billion profit for a given year and had $100 billion in assets, its return on assets would be 1%. Investors generally want to see an ROA of 1% or higher.
• Efficiency ratio: A bank’s efficiency ratio is a percentage that tells investors how much the bank spent to generate its revenue. For example, a 60% efficiency ratio means that a bank spent $60 for every $100 in revenue it generated. You get the efficiency ratio by dividing noninterest expenses (operating costs) by net revenue; lower is better.
• Net charge-off ratio: This is a metric that shows how much of the bank's loan portfolio is written off as uncollectible, expressed on an annualized basis. Essentially, a 1% charge-off ratio implies that $1 million annually of every $100 million in loans is bad debt. This is an important metric in tough economies, and it can let investors know how a bank's loan portfolio is performing relative to peers.

The cyclicality of bank stocks

Banks can be a great place to invest, especially in strong economies. When consumers are confidently spending and unemployment is low, profits tend to grow and loan defaults are typically kept in check. On the other hand, banks tend to perform quite poorly during recessions and other uncertain times. In investing terms, this means banks are a cyclical business.

There are a couple of reasons why banks tend to perform poorly during recessions and other difficult economic climates. For one thing, they can face a wave of loan defaults if unemployment rises. Also, consumers pump the brakes on spending during recessions, which leads to lower demand for loans.

We've seen a lot of recession fear take shape over the past year or so. With inflation still near a multi-decade high, there's reason to believe consumers could start having trouble paying their bills, especially if unemployment spikes higher. Despite the potential for higher interest income in a rising-rate environment, this has put pressure on bank stocks in recent months since a drop in loan demand and a spike in defaults are legitimate possibilities.

As previously mentioned, some parts of investment banking -- such as trading and underwriting -- tend to do better in turbulent times. Banks such as JPMorgan Chase and Goldman Sachs (GS -2.38%) that have large investment banking operations could be helped by tough times, while banks that largely focus on commercial banking, such as Wells Fargo (WFC -2.25%), could be at a temporary disadvantage.

It's also worth mentioning that the United States occasionally faces a banking crisis, and customer panic is a very real risk factor. Consider the failure of SVB Financial's (NASDAQ:SIVB) Silicon Valley Bank. It started when the bank reported that it needed to sell assets unexpectedly at a loss. But the bank collapsed when customers panicked and withdrew tens of billions of dollars from the bank.

Warren Buffett loves banks

Berkshire Hathaway (BRK.A -1.32%)(BRK.B -1.32%) CEO Warren Buffett is known as one of the best stock investors of all time. During his 59 years at the helm of the company, Buffett has delivered annualized returns more than double those of the S&P 500, and the investments he’s chosen for Berkshire’s massive stock portfolio over the years are a good reason why.

If you take a glance at Berkshire’s stock portfolio, you’ll notice one major trend: Buffett owns quite a few bank stocks. Berkshire owns stakes worth $1 billion or more in a few different bank stocks, including almost 13% of Bank of America, more than 20% of American Express (AXP -1.42%), and a large position in U.S. Bancorp.

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The bottom line on bank stocks

Although it’s not necessarily a smart idea to buy any particular stock just because a billionaire owns it (even Warren Buffett), there does appear to be some value in the banking industry if you're a patient, long-term investor who can tolerate some short-term volatility. So if you don’t have much exposure in your portfolio, one or more of the rock-solid banks discussed here could be a good fit for you.