1 Reason Warren Buffett Would Love BofI Holding

When I think about BofI Holding , the parent company of Bank of the Internet, the first thing that comes to mind is Warren Buffett's observation that only low-cost operators or businesses in a protected, and usually small, niche can sustain high profitability levels in industries such as banking.

This fundamental insight has molded how I think about and analyze banks ever since reading Buffett's 1987 letter to the shareholders of Berkshire Hathaway.

The reason it comes to mind in the case of BofI Holding is because it's one of the lowest cost bank operators in the industry today. In the three months ended July 30, only 32.7% of BofI's net revenue was consumed by operating expenses. That's almost twice as efficient as the average bank, which spent 60.6% of net revenue on expenses in the first quarter of 2015, according to the latest FDIC data.

This metric is known as the efficiency ratio. A lower number is better than a higher one because it means that a greater share of revenue is left over to cover future loan losses, pay taxes, distribute to shareholders, and to boost book value.

It also matters because there seems to be a relationship between a bank's efficiency ratio and its loan losses. Namely, banks that operate more efficiently also have a tendency to experience lower loan losses, and vice versa.

This relationship follows from the fact that less efficient banks must look elsewhere to offset the impact of high expenses on their bottom lines. And the easiest place to find extra revenue is to originate riskier loans in exchange for higher net interest income.

Columbia Business School professor Charles Calomiris alludes to this in Fragile by Design: "Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind."

In BofI Holding's case, the reason it's able to operate so efficiently is because it doesn't rely on a sprawling and expensive branch network to gather deposits. It looks instead to the Internet, over which it offers a variety of accounts and financial products.

One downside to this approach is that BofI Holding faces higher funding costs. To attract deposits, it pays higher interest rates on depository accounts than most other banks. In its latest quarter, for instance, it paid 0.75% on its interest-earning deposits. Meanwhile, Bank of America and Wells Fargo pay less than 0.07% for the same type of funds.

It's important to note, of course, that BofI Holding's efficient operating model allows it to outprice its competitors for deposits while still generating double-digit returns on equity -- its ROE in the first three months of this year was an 17.9% compared to around 11% for even the best run traditional banks. But by relying on price-sensitive deposits, BofI Holding is uniquely susceptible to deposit flight when interest rates normalize or in the event that its banking subsidiary suffers large loan losses which scare depositors. These aren't issues that should concern investors now, but they could rear their ugly heads in the future.

In short, while BofI Holding isn't without its own set of challenges, its low-cost expense base gives it a legitimate shot of earning outsized returns for years to come.

The article 1 Reason Warren Buffett Would Love BofI Holding originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America, BofI Holding, and Wells Fargo. The Motley Fool owns shares of BofI Holding 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.

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