How to Recession-Proof Your Bank Stock Portfolio

By Markets Fool.com

No one likes to lose money -- and investors are especially vulnerable to losses when the economy enters a recession. Unfortunately, the occasional economic downturn is a guarantee. To help protect us against this market reality, let's explore how one key metric can dramatically boost your bank stock performance when the economy hits a bump in the road.

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The secret sauce: efficiency
A bank's efficiency ratio is a measure of its non-interest expenses divided by its net revenue. The lower the resulting percentage, the more efficient the bank.

At a theoretical level, a more efficient bank can produce strong profits without taking on excess risks. Because their operations eat up a smaller percentage of revenue, more efficient banks are not enticed to chase riskier, high-yielding assets to boost profits. They can instead stick to originating solid loans at competitive prices -- the kind of loans that are far less likely to go bad if the economy heads south.

To test this theory, I pulled efficiency ratios for five prominent U.S. banks, as well as industry averages for all U.S. banks with total assets greater than $10 billion. Data for individual banks was sourced from S&P Capital IQ, and industry data comes from the FDIC's Quarterly Banking Profile.

Taken together, the data looks a bit messy. But don't worry -- we'll break it down further from here.

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The key takeaway at this point is that these banks have historically reported efficiency ratios better than the industry average, with a few exceptions beginning at the start of the financial crisis.

From this point, I averaged the efficiency ratio for each bank during the full 18-year sample and compared that number with each stock's performance.I've included the S&P 500 in the chart for comparison to the broader markets.

Average Efficiency Ratio Stock Price Change
Fifth Third Bancorp 53.9 7.8%
M&T Bank 53.9 330%
Bank of America 58.9

(29%)

US Bancorp 50.3 344%
Wells Fargo 59.1 401%
Large Bank Industry Average / S&P 500 59.5 175%

At this point, there is no obvious relationship between the efficiency ratio and stock performance at all. Each of the banks tested have reported better-than-average efficiency ratios during this period, and each stock's performance has varied wildly.

Wells Fargo, for example, has the worst efficiency ratio on average, yet the stock is up 400% during this time period. Fifth Third's ratio is a full 500 basis points lower than Wells', and the stock is up barely 7%.

Efficiency shines brightest in the darkest of economic times
In recessions, the efficiency ratio earns its reputation. Let's do the same test but segment the data to just 2006 through 2013.

Average Efficiency Ratio Since 2006 Stock Price Change Since 2006
Fifth Third Bancorp 60 (51%)
M&T Bank 55.3 1%
Bank of America 65.1 (67%)
US Bancorp 49.7 24%
Wells Fargo 57.8 52%
Large Bank Industry Average/S&P 500 60.3 44%

Now we can finally see where the rubber hits the road. Since 2006, Bank of America has the worst average efficiency ratio of these banks. The stock has performed just as poorly.

The second-worst efficiency ratio goes to Fifth Third Bancorp; its stock has dropped 51%. Wells Fargo's efficiency ratio has improved over its long-term average, dropping to 57.8%. Its stock was the best-performing of this group and the only to outperform the S&P 500.

Likewise, US Bancorp has reported very strong efficiency ratio since '06, and its stock has performed in kind. M&T Bank is the lone exception, with a solid efficiency ratio and a middling stock performance.

Foolish takeaway
Is there a perfect one-to-one correlation between a bank's efficiency ratio and its stock performance? No -- this is no golden ticket. But there is an interesting relationship that emerges between the two, particularly during tough economic times.

There's a lot more analysis needed to truly find a recession-proof bank stock. If nothing else, this exercise shows that the efficiency ratio is a good place to start your bank stock research.

The article How to Recession-Proof Your Bank Stock Portfolio originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Fifth Third Bancorp, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.