3 Reasons BofI Stock Is a Buy

By Michael Douglass Markets Fool.com

I'm a growth investor at heart, which is why you don't see a bunch of banks in my portfolio. But there is one in there, and for good reason: I believe that Bank of Internet (NASDAQ: BOFI) (or BofI for short) has all the makings of a long-term winner. Here are three reasons why.

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Image source: Getty Images.

The credit cycle

Creditworthiness is the name of the game for banks; if you're loaning out money to people who won't pay it back, that's going to be a big problem long term.

I wrote "long term" there intentionally, because one of the real difficulties with banks is the fact that aggressive lending often pays off in the short term. If the economy is humming along and people are levering up to buy their third house, the bank that underwrites that extra mortgage is going to show a lot more growth than the conservative lender with higher standards. When the credit cycle turns and people start defaulting, of course, the conservative lender survives while the aggressive lender takes a nosedive.

There are a lot of different ways to wrap your head around the quality of a bank's underwriting, but my favorite approach is the ratio of non-performing loans (or NPL) to total loans. By that measure, BofI has done incredibly well. Over the last ten years, BofI's NPL ratio has never exceeded 1.5% of total loans, which happened in the fiscal year ended June, 2010. In their fiscal years ending December 2010, New York Community Bancorp and M&T Bank, two notably conservative lenders, reported NPL ratios of 3.5% and 2.2%, respectively, according to data from S&P Market Intelligence.

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I like BofI's consistently low NPL ratio -- it speaks to quality underwriting. That's particularly important given that BofI is, well, not a terribly typical lender. It primarily underwrites jumbo mortgage loans -- mortgage loans above $417,000 or $625,500 in high income areas. Also, 68% of its mortgage portfolio is located in California. Normally, that's abnormal and risky enough that I would stay far away. Yet it's done a great job of managing that risk in the way that matters most -- they're lending to people who consistently pay them back (even during the Great Recession).

Growth and expansion

My favorite investments are growing revenue quickly, and growing more profitable as they scale. BofI checks both boxes.

Gross loans have grown more than tenfold in the past decade, from $535.1 million in the twelve months ended June 30, 2006 to $6.6 billion in the twelve months ended September 30, 2016. Net interest income increased more than twenty-fold over the same period, from $10 million in 2006 to $271.7 million -- highlighting margin expansion, as net interest margin bumped from 1.5% in 2006 to 3.9% in the trailing-12 months.

And yet, even with that expansion, BofI has done a great job of leveraging its place as an internet bank to keep its expenses low, as measured by reducing its efficiency ratio from 51.2% in 2006 all the way down to 34.4% in the last twelve months. That's supported a nearly twentyfold increase in EPS over the past ten years.

And they've done it, as noted previously, while keeping their credit risk very low. That's rare.

That's the kind of management I like to see.

Good valuation -- for a reason

BofI is currently trading for about 2.6x tangible book value (or TBV). For most banks, that's expensive -- but most banks don't sport an efficiency ratio of 34%, strong revenue growth, expanding profitability, and such impressive underwriting. BofI's current valuation is actually a bit on the low side of its historical valuation, with multiples having peaked as high as nearly 5x TBV a few years back.

Now, when I see a stock that's valued reasonably and is killing it on all its other metrics, I usually expect to learn that there's more to the story than the ratios. The market, after all, isn't in the habit of undervaluing good businesses for no reason.

And, indeed, BOFI has a big potential problem: Litigation. BofI was accused in late 2015 of firing a junior auditor for identifying potential wrongdoing at the bank to regulators. Since then, there have been a flurry of lawsuits against the bank, none of which have resulted in findings of wrongdoing. Nonetheless, those suits are ongoing, so it's something anyone considering the stock should be aware of. Particularly given the fact that roughly 32% of shares are sold short.

The key question

The entire thesis around BofI comes down to one question: Do you think the managers are crooks? If the answer is yes, stay away -- because if there's wrongdoing, ultimately it will come out. And that will rock both the underlying business and the stock price. If you think management is basically trustworthy, then the three main points I've highlighted above (great underwriting, strong growth and expansion, and good valuation) make the stock a buy, at least in my book.

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Michael Douglass owns shares of BofI Holding and owns the following options: short January $20 puts, and short February $25 puts. The Motley Fool owns shares of and recommends BofI Holding. The Motley Fool has a disclosure policy.