You needn't feel guilty if you get caught with these two bank stocks. Image source: iStock/Thinkstock.
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A good bank stock can go a long way toward helping you get rich or prepare you for retirement. But as with most good things, high-quality bank stocks are few and far between.
The two that I believe are best for long-term investors are Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB). Their shares trade for a pretty penny -- they're among the most expensive in the industry -- but these banks' current and historical performances justify the premium.
The key to investing in banks is simple. In the first place, you want a bank that creates value for shareholders. The best way to gauge this is by looking at a bank's return on equity, which is computed by dividing a bank's net income by its shareholders' equity.
As a general rule, you only want to invest in a bank if its return on equity exceeds its cost of capital -- or is likely to at some point in the not-too-distant future. This metric factors in the risk-free rate of return as well as a specific stock's volatility. While you can calculate the cost of capital for individual bank stocks, I usually use 10% as a benchmark.
Exceeding this value hasn't been a problem for either Wells Fargo or U.S. Bancorp. Over the last year, Wells Fargo generated a 13% return on equity, according to YCharts.com. U.S. Bancorp produced a 14.4% return on equity over the same stretch.These figures rank Wells Fargo and U.S. Bancorp at the top of their peer group -- only Fifth Third Bancorp and JPMorgan Chase have also earned double-digit returns on equity, albeit lower ones.
Data source: YCharts.com. Chart by author.
Consistently high profitability
But it's not just the ability to earn a high return on equity that matters. Many of the worst-performing banks over the past decade reported high profitability figures in the lead-up to the financial crisis only to see all of the corresponding gains to shareholder value evaporate once losses began to mount. In 2005, for instance, Citigroup (NYSE: C) reported a 22.4% return on equity. Three years later, that fell to negative 30%.
What matters just as much is thus the ability to earn high returns through all stages of the credit cycle (the credit cycle tracks the economy, as good economic times equate to low loan losses, and vice versa). This is necessary in order to maximize long-term returns, as the rate compounding returns, which gains momentum with time, is fueled by profits and throttled by losses.
Few banks do as well on this score as Wells Fargo and U.S. Bancorp. Neither reported an annual loss during the financial crisis, which was the worst economic downturn since the Great Depression. And although Wells Fargo's return on equity dipped to 4.6% in 2008, that was because the bank, out of an abundance of caution, took a much larger loan loss provision than was necessary.
Data source: YCharts.com. Chart by author.
Last but not least: Valuation
Just because a bank earns consistently high profits doesn't necessarily mean its stock is a buy. You also have to factor in valuation. Even the best bank stock can perform poorly if you pay too much for it.
The metric that bank investors use to gauge bank stock valuations is the price-to-book-value ratio. It compares how much a bank claims it's worth to how much the market says it's worth. If the market says a particular bank is worth twice as much as the bank claims, than its price-to-book-value ratio would be 2.
Data source: YCharts.com.
An old adage in the bank industry is that you want to buy at half of book value and sell at two times book value. But even though the logic behind this is sound, it's impossible to pick up a quality bank stock for that cheap.The objective is, accordingly, to buy great bank stocks at reasonable valuations.
In this case, I believe that means buying shares of these banks so long as they trade for less than two times book value -- which both of these banks do. According to YCharts.com, Wells Fargo trades for a 40% premium to its book value, while U.S. Bancorp is priced at a 76% premium. These valuations aren't bargains, but they're not unreasonable either.
I'll be the first to admit that this final threshold is easy for banks to satisfy, and this is particularly true right now, given the downbeat forecast for the financial industry. At the same time, it's worth keeping in mind Warren Buffett's point that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
In short, Wells Fargo and U.S. Bancorp are wonderful companies trading at fair prices.
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John Maxfield owns shares of US Bancorp and Wells Fargo. The Motley Fool owns shares of and recommends 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.