The Universal Banks: Bank of America, Citigroup, and JPMorgan Chase

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Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel take a close look at the largest universal banks in the U.S.: Bank of America (NYSE: BAC), Citigroup (NYSE: C), and JPMorgan Chase (NYSE: JPM). Here's what investors need to know about these three banks' business models and the right metrics to evaluate each one.

A full transcript follows the video.

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This video was recorded on Jan. 29, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, January 29th. We're taking a deep dive on the so-called universal banks today. Those keeping score at home, that's Bank of America, Citigroup, and JPMorgan. I'm your host, Michael Douglass. I'm joined by Matt Frankel as per usual. Listeners, this is part two in a three-part series we're running on the big banks. Part one was our December 11th episode, breaking down the investment banks -- that is, Goldman Sachs and Morgan Stanley. We had some other news-driven and end-of-year stories to finish up between then and now, but not we're on part two, universal banks. As you can imagine, at some point we'll be doing part three, the commercial banks. Now, we'll be running these banks through the Anand Chokkavelu framework. Anand is the managing editor of fool.com, and back in 2014 he wrote a really fantastic article breaking down how to think about a bank and how to understand its underlying business model. We'll be running them through that framework, just like we did with the investment banks on December 11th. His framework for how to understand a bank stock is a great accompaniment to this episode, so shoot me an email at industryfocus@fool.com if you need the link. We're not going to get too much into the details of the various ratios, because he explains the reasoning behind them. Again, that's a useful accompaniment to this episode.

With that in mind, let's first talk in generalities. Matt, I'll finally let you start talking. [laughs] What's a universal bank, and how is it different from another kind of bank?

Matt Frankel: You pretty much have three kinds of banks. You have commercial banks, which are your typical savings and loans. Wells Fargo is a good example of this. Most of their business is simply taking in money as deposits and loaning it out to customers and profiting from the spread between them. On the other hand, you have investment banks like Goldman Sachs and Morgan Stanley. They do M&A advisory, they do trading, they have equity and debt underwriting. They're the banks that are behind the IPOs that you hear about. Universal banks kind of do both. They do traditional commercial banking, which is why a lot of listeners probably have accounts at Bank of America, Citigroup or JPMorgan Chase. And they also do investment banking activities. They all have big wealth management businesses, they participate in advisory and underwrite debt and equity offerings and have big trading desks, which is where a lot of their assets are, as we'll get to in a minute.

Douglass: Right. The first place you can see this is by looking at their income statement. You look at each bank's income statement and it will tell you that there are different revenue types. All in cases, between 41% and 49% of their revenue comes from consumer banking. 41% for Bank of America, 49% for Citigroup, 48% for JPMorgan.

Frankel: Yes. The rest is spread among various either commercial or investment banking activities. Bank of America, they name their business segments weird, so if you're looking at their income statement it might be a little tough to figure out what's what. But to run down, Consumer Banking is obviously what you just referred to, with the 41%. They have another one called Global Wealth and Investment Management, which is their brokerage business and things like that. Global Banking is the M&A portion of their investment bank, M&A and underwriting. And then, you have Global Markets, which is their trading desk. They break it into two. Whereas the other ones are pretty straight forward if you're reading an income statement. Citi's is called the Institutional Clients Group, which refers to all of their investment banking stuff. JPMorgan's is actually called the Corporate and Investment Bank, so obviously that's what that's talking about. Bank of America is the only one that doesn't have straightforward names to their business segments. So, just keep that in mind if you're reading any earnings reports in the future from these three banks.

Douglass: Right. The key takeaway here is, they all have similar-ish revenue mixes. I mean, sure, Bank of America has 23% of their revenue coming from Global Banking, whereas JPMorgan, on the Commercial Banking side, which is their most equivalent, is 9%. But it's all pretty similar. These are universal banks, meaning that their consumer banking is the largest individual part of their revenue mix, but they have substantial percentages elsewhere.

Frankel: Yeah, definitely. All three are also pretty similar in size. Citigroup is the smallest of the three, if you can even use that world, with a little over $1.8 trillion in assets. JPMorgan is the biggest with a little over $2.5 trillion. But when you really think about it, that's not that big of a range. These are all comparable banks in size.

Douglass: I was about to say, what's $700 billion between friends?

Frankel: [laughs] Right. They're all also pretty similar in terms of the amount of money they loan out. All three have about a third of their assets in loans, give or take. All three have all the loans well covered by deposits. So, for the most part, they're loaning money from low-cost deposits, just like most commercial banks do. The rest of their assets are mostly tied up in their trading desks. All three are comparable in terms of efficiency of the business. We've talked about efficiency ratio before. They're all within a couple of percentages of each other. And all have grown at pretty much the same rate over the last couple of years. All three had either 6% or 7% loan growth over the past year, revenue was between 1% and 3%. So, it's not like one is really outpacing the other three. They're actually all pretty similar, which is kind of an ongoing theme here.

Douglass: Yes. Something we talked about right before hand was ... of course there are differences, but when you're looking at these from a really long-term investing standpoint, really broadly, it's not an enormous difference at this snapshot in time. A couple of points that I'll note. Matt, as you pointed out, their loans are well covered, or over-covered, if you will, by deposits. They have more in deposits than they're loaning out. But, because of all those securities, they're also having to take on debt of one kind or another. And debt is about the size, equivalent to about a third or half of their deposits. So, that's sort of that additional money they're taking in to juice up their balances so they can then take on securities and things like that. Efficiency ratio, as you pointed out, between 58% and 62%. Remember that 60% is the number that you want to see, and you want to see lower than that where possible. Bank of America is a little higher, Citigroup and JPMorgan are a little bit lower. But that's how that all works.

Now, thinking about the next part of Anand's framework which is, how much money are they making and how are they making that money, to me, this is where things get really interesting. Of course, as we've talked about a couple of times, I don't know if anyone noticed, these are universal banks. [laughs] I think we've said that a couple of times now. And as a result, net interest income, while a substantial proportion of their net revenue, isn't their entire net revenue. And in some cases, it's really about 50-50 between net interest income and non-interest income, which is a different thing than you would normally expect if you looked at mostly your regional and relatively small-cap banks.

Frankel: Bank of America and JPMorgan are actually almost 50-50, a little bit in favor of interest income. Citi is about two-thirds interest income and one-third non-interest income. And to clear it up, non-interest income is things like advisory fees, wealth management fees, pretty much anything other than them profiting from the difference between money they're loaning out and money they're taking in.

Douglass: Right. With all of that in mind, let's go ahead and take a look at part two, which is, how expensive is the bank? When it comes down to it, valuation is really critical in banks, because as you mentioned, Matt, we're not seeing, for these big banks, a ton of growth. I mean, sure, listen, single-digit deposit growth and loan growth is great. And single-digit revenue growth is great, too. You're not going to tend to see double-digit growth here. So, valuation becomes really important because these are large, mature companies.

Frankel: Yeah. There's a couple of different ways you can value bank stocks. Price to earnings is the traditional valuation metric, it's used to pretty much for every sector of the market. And that's definitely helpful here. My favorite way to evaluate banks is the price to their tangible book value, or just their book value, depending on which one you're looking at. Price to tangible book value is how much a bank's stock is trading for relative to the value of its assets. In other words, if a bank decided to close its door today and sold off all of its assets, how much could it reasonably get? If you include things like good will and brand name, stuff like that, that's your price to book value. If you don't include any of those intangible items, as the name implies, that's your tangible book value. As far as these three banks go, this is where it starts to get a little bit different. Citigroup is by far the cheapest of the three. They trade at just over 1.1X their book value, 1.3X their tangible book value. Bank of America is the middle one here. They trade at about 1.35X their book value, 1.9X their tangible book. JPMorgan is the expensive one, about 1.75X their book value and 2.2X their tangible book. With banks, though, you have to remember, you're getting what you pay for. Citigroup has a lot of risky assets on its balance sheet, mainly left over from the financial crisis. And you see that, as your valuations go up among these three, you see less and less of that risky stuff on there.

Douglass: One of the key things to think about when investing is not just returns. Everyone talks about returns. But also, risk-adjusted returns. I don't personally view risk as volatility. I view risk as the likelihood that everything goes belly up. Because, for me, I'm not concerned about volatility, because I'm 28, so I have plenty of time to ride out lots of volatility. But for me, the really key question is, what's the risk that things don't pan out well? And so, I will tend toward safer businesses for exactly that reason. Now, to be clear, Citigroup is perfectly fine. But, you do tend to get, when you adjust your potential returns for risk, that does sometimes create a different picture than what you had when you were just looking at potential returns. So, I would throw that out there as a caution for anyone, particularly some growth-minded investors like me, to think about.

But, yeah, as you pointed out, you get what you pay for, and I think that actually segues us very nicely to part three, which is, what is the bank's earning power? And here is where JPMorgan certainly starts to pull away from the pack a little bit. Return on equity, you want to see 10%. JPMorgan's was 11%. Citigroup's was 7.3% and Bank of America is around 8%.

Frankel: Yeah, same goes for return on assets. You want to see around 1% here. JPMorgan's was 1.04%. Citigroup's was 0.87%, Bank of America's was 0.93% for the year. Like I said, efficiency, they're all pretty much evenly matched. But JPMorgan really stands out from the pack here. That means they're earning more than enough money to cover their cost of capital. Bank of America is getting there. They're improving very rapidly, which is why I think they command a premium valuation to Citigroup, even though the metrics don't really justify trading for a 30% premium or whatever it is. JPMorgan is definitely the most profitable today. Bank of America is the most rapidly improving of the three, is the way I put it. That's where you get the three levels of valuation that you see between these.

Douglass: That turns us to part four, which is, what risk is the bank taking on to achieve those earnings? This is one of the tougher things to quantify, particularly in a many-year bull market. Frankly, your non-performing loans are going to tend to be a roughly small percentage of things, even if you're lending out in a kind of risky fashion, because the economy is humming along, unemployment is going down, wages are going up, people in general are doing pretty well. The real key when thinking about risk is what happens when the tide goes out, and when the economy turns. Right now, you look at all three of these banks, their non-performing loan percentages are between 0.6% and 0.7% of gross loans. That's nothing. And their allowances, which is the money that they're setting aside to cover that, is, in most cases, about double what's currently non-performing. That's a very conservative, very appropriate amount of money to set aside, recognizing that not every loan gets paid back. So, I feel fine about the risk outlook for now. I think one of the key things to consider, though, is that all three of these banks suffered substantially when the financial crisis came through. And one of the big questions that any investor is going to have to ask going forward is, what did they learn, and how are they going to do things differently next time?

Frankel: One thing I'd add to that is, in a couple of months, you'll start to see headlines about the banks' stress tests. This is where that information can be very useful, because it can give you an idea of what can happen if things don't go very well. I always say, every investment recommender looks like a genius when the market keeps going up and up. You can't make bad picks. And the same kind of logic applies here. Banks look great when everything's going fine, consumers have plenty of money, unemployment is at a historic low. But, it's when unemployment jumps to 6% or 7%, wage growth goes to a standstill, you have a deflationary environment, that's when you start to see where the really good banks are. And this is what I'd say -- in a few months, when you start seeing the stress tests in the news, that's something to pay attention to.

Douglass: Yes, because one of the key things to remember with banks is, they are institutions that use a fair amount of leverage. So, when thinking about that leverage, that means they don't keep enough cash to pay off everything on the spot. That's why you had runs on the banks back in the Great Depression and all that. The idea here is, you want to make sure they have appropriately priced their risk profile. Fortunately, the stress tests are the best guess that the U.S. regulatory regime has for how to basically grade whether they're doing that appropriately. That's going to be very, very important to look at.

With that in mind, let's talk about these companies going forward. Of course, one of the weaknesses of the framework that Anand developed is, it's really good for a snapshot in time only. It's not necessarily that's helpful if you're looking really far in the future or really far in the past, with the usual caveats that nobody can predict the future. But let's talk about what are going to be some big catalysts for these companies in the coming months and years. Of course, the first one is something that's been in a lot of headlines if you've been watching the stock market recently, and it's tax reform and what its implications are for businesses.

Frankel: Yeah. Banks in particular, tax reform is kind of interesting. It was negative at first. We talked about this a little bit last week. But tax reform caused a lot of these banks, all three of these that we're talking about here, to take pretty big hits. They carry what's called a deferred tax asset on their balance sheet, pretty much old losses they can use to lower future taxes. Citigroup's is enormous, as you might imagine. They all took pretty big hits this past quarter, which is why, if you read any of the bank earnings reports, they're kind of tough to follow in some cases.

Douglass: Right. [laughs]

Frankel: But, generally speaking, all three of these banks operate at effective tax rates in around the 30% ballpark. Bank of America's last year was 29%, Citigroup's was 30%, JPMorgan's was 28% in 2016, 32% this year. So, these are pretty high tax rates. The corporate tax rate drop to 21% will undoubtedly produce a big boost in profits on these banks' income statements. This is why you've seen in the headlines, Bank of America giving out $1,000 bonuses to employees, banks raising their minimum wages. Just to give one example of a bank that's quantified this, JPMorgan estimates that their effective tax rate is going to drop to 19%. This is a bank that's generating billions and billions of dollars in profit each quarter. Now you're telling them they can keep roughly an extra 10% of that. So, this is a big deal. Some of it is going to go to employees. Some will eventually be competed away, which is kind of an after-effect of tax reform in historical cases. But some of this is just going to boost their returns, boost to profitability.

Douglass: Right. And they've certainly been upfront about the potential that this could mean additional share repurchases and higher dividends. So, that's certainly something that all bank investors should be keeping an eye on for the next year. I think it's easy to say, "We want to return $X billion to shareholders." What I'm always more interested in seeing is how and in what way is they plan to reinvest at least a portion of that money into the business. Is it improving online capabilities? Is it figuring out how to do better automation so that they can remove some costs from their structure? Is it developing new platforms, new ways of doing things? There's a lot of opportunity for a bank that is forward-looking and can really think through how to better thread the needle. So that's something I always want to see.

Another thing to keep in mind for all banks, just about, is interest rate increases. The Fed has signaled that they're planning to put in three interest rate increases next year. Some of the big banks are even expecting perhaps more than that. So, there's a lot of opportunity there for them there to basically boost that net interest margin further. Particularly for Citigroup, that's good news. Although, frankly, Bank of America and JPMorgan are still about 50-50 interest income vs. non-interest income, so that's certainly an opportunity for them as well.

Frankel: Yeah. Bank of America actually has a disproportional share of low-cost deposits, like savings and checking deposits that they're paying virtually zero interest on. So, Bank of America has a lot of that, so they should see a nice little benefit here. These won't benefit as much from interest rate margins as, say, a pure commercial bank like Wells Fargo. But, we'll see.

Douglass: Yeah. And that's, again, because there's that substantial proportion that's not non-interest income. The third thing to keep in mind looking at these guys broadly is, the stock market is doing really well. Certainly, I think we've all noticed that. That means wealth management balances are up. All three of these banks have substantial wealth management divisions. So, that's good for them because that means their assets under management fees are going up. But, if you've been listening to Industry Focus: Financials for a little while, you will probably expect what's coming next, trading desk revenue is down because volatility is down. So, it's one of those things where, the banks have this kind of safety net that helps them in a counter-cyclical way, so that when the economy is doing poorly, the stock market is doing poorly, usually trading desk revenue boosts. But, flip side, that does mean that, right now, it's a bit of a drag for them.

Frankel: Yeah. A couple of things to watch in this case. Wealth management balances, yes, they're going up and up and up for market performance. The term you want to pay attention to on these earning statements are net inflows, or outflows, unfortunately. An inflow means the bank is taking in more investor deposits than are being paid out as withdrawals. This means they're going to grow over the long run, whether or not the market continues to go up. That's kind of a sign of a healthy wealth management business, more so than just the market going up. Trading revenue, as Michael said, can help to balance out poor market performance, which actually gives these universal banks an advantage over pure commercial banks. It gives them a rising income stream when things go poorly. A bank that relies heavily on trading revenue, Goldman Sachs, never made more than they did in 2009, just to give you an idea. So, it's kind of an interesting dynamic on the investment banking side. But, yeah, wealth management, definitely keep an eye on the inflows. Some banks are actually starting to experience some outflows, which is concerning, so keep an eye on that.

Douglass: Yeah, for sure. So, with all that in mind, Matt, we talked a about this a little bit before the episode, but I looked at all three of these banks and I say ... I think Citigroup is cheap for a reason, so I tend to shy away from it. I've always believed in trying to buy "the best" business where possible, and paying up for that quality if I need to. I tend to approach appliances and running shoes the same way, for better or for worse, just on the principle that they'll probably last longer. But, I think Bank of America and JPMorgan each have things that look good about them and things that I'm not as excited about. I am notoriously gun-shy around the big banks, I've never actually bought any of them, and that's just because I tend to think that they aren't really primed for market-beating returns and market-beating growth long term. Plus, their balance sheets can be a little bit opaque. Even with all that we've explained, there's a lot that we haven't. And that, as an investor, makes it hard for me to pick one to invest in or even a group to invest in.

Frankel: Yeah. Out of the three, I would pick Bank of America, just because -- well, first of all, I own Bank of America stock. I bought it when it was a whole lot cheaper than it was today, to be clear. And this is what Michael was talking about, it's kind of tough to see where they would have market-beating returns over the long run. But in the wake of the financial crisis, Bank of America for $10 a share really looked pretty phenomenal. So, having said that, if I had to buy one today, I would pick Bank of America just because I think their management team has done a fantastic job of integrating technology to become more efficient, generally improving their asset quality, really strategically reducing their footprint, running a leaner and much higher quality operation than it was a few years ago. And like we said, they're not even at the 10% ROE and 1% ROA. So, I think they have a ways to go still. So, if I had to buy one today, I'd pick Bank of America.

Douglass: Good to know. Folks, which would you buy if you had to pick right now? Shoot us an email, industryfocus@fool.com. I'm curious to hear what you think. Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Anne Henry. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!

Matthew Frankel owns shares of Bank of America. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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