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The Big 4 U.S. Banks: What Investors Need to Know

Matthew Frankel, The Motley Fool

When it comes to U.S. banks, there are four that are in a league of their own when it comes to size: JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC).

In this episode of Industry Focus: Financials, host Shannon Jones and Fool.com contributor Matt Frankel take a closer look at the big four and what investors should know when evaluating these institutions.

A full transcript follows the video.

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This video was recorded on July 9, 2018.

Shannon Jones: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, July 9th, and today we're talking big banks. That's right -- JPMorgan Chase, Bank of America, Citigroup and Wells Fargo. We'll be diving into what investors need to know about how each of these banks operate, what to watch for, and how the banks stack up valuation-wise. This is all ahead of earnings, slated to begin later this week. 

I'm your host, Shannon Jones, and I'm joined via Skype by our financial specialist/ guru, Matt Frankel. Matt, great to be in the studio with you today!

Matt Frankel: Always good to join you guys!

Jones: Awesome. Before we dive into the four big bank stocks, let's actually set the stage, Matt. Let's talk about, in a very broad sense, how banks make money and why it's important to understand this.

Frankel: There are two broad categories of how banks make money. The first is commercial banking, which, at its core, is the savings-and-loan type bank -- loaning out customers money, charging interest, and making a profit from the cost of money to you and the cost of money to the customer. That's where commercial banks get their profit margins. On the other hand, you have things like what are known as investment banks, which deal with mergers and acquisitions, they advise on IPOs and equity and debt underwritings. They also deal with the wealth management side of the business.

Those are two broad baskets that you can put banks in. Because these are the big four banks -- they are by far the largest four banks in the U.S. -- three out of the four deal with both of these to one degree or another. It's important to know the distinction, because both have their own risk factors, which we'll get into in a little while, and both have their own makeup in terms of profit margin, what's expected, what's considered good, what's considered bad, how credit quality works with those. 

It's important to understand, to start off with, the distinction between commercial banking, which is what you would normally think of when you think of a bank, and investment banking, which is increasingly becoming more of most banks' business these days.

Jones: Exactly right. Key thing here is, it's important for investors to not only understand where a bank is generating its revenue from, but also understanding the makeup of those revenue streams -- as Matt was talking about, consumer banking vs. investment banking, foreign vs. domestic -- and really understanding how they differ in respect to one another. Matt alluded to this a little bit -- of course, when it comes to looking at how the banks make money, how they become profitable, you'll also want to know, just how good are they at lending money to those that aren't at a risk of default? That is a real key area in terms of the quality of their loan portfolios, especially on the commercial side.

With that being said, let's dive into how the four big banks make their money. Let's start with the big behemoth here, Matt. Let's talk about JPMorgan Chase. For our listeners, they are scheduled to release earnings before opening bell on Friday, July 13th. This is the largest bank of the big four by assets, and really, in all respects, has been firing on all cylinders. Matt, let's talk a bit about their bread and butter business and how they make money.

Frankel: Regardless of valuation, if you were looking for a best-in-breed bank, it's really tough to make the case against JPMorgan right now. As Shannon mentioned, they are the biggest of the four, and they've consistently grown since the financial crisis. They didn't do that poorly in the financial crisis, first of all. They've grown well since the financial crisis. They've pretty much been scandal-free. The growth continues. They continue to put up impressive numbers. 

To quote one number, their loan portfolio grew by 8% year over year in the most recent quarter. They're benefiting really big from things like tax reform. Their investment banking division is doing really well. They actually had the No. 1 market share in global investment banking fees for the first quarter. JPMorgan is the best in breed. Apple is to the tech world as JPMorgan is to banking. If you want a bank that's really big, really good at what they do, growing rapidly, and doing everything right, JPMorgan is probably the one you want to look at.

Jones: In addition to growing in just about every area possible, just to dig into the specifics from last quarter, Matt, you mentioned the core loan portfolio growing 8%. Deposits also grew 6%. This was all while maintaining the quality of its loan portfolio, which is huge. You saw that provision for credit losses actually declined 11% year over year, and the percentage of non-performing assets were also down 7%. What that really means from an investing perspective is that JPMorgan is growing responsibly and can really grow quite impressively. There's not much to not like about JPMorgan.

Another thing that's really interesting is their efficiency ratio. Basically, what that is, the efficiency ratio is a quick and easy measure of a bank's ability to turn its resources into revenue. We love it when we see a bank's efficiency ratio under 50%. That's awesome. Under 60% is pretty good, too. JPMorgan last quarter was right there in the sweet spot at 56%. That was actually the lowest among the big four.

Also, in terms of profitability, a couple of other metrics to be aware of -- JP Morgan had a 15% return on equity. For listeners that aren't as familiar with that, it's basically a ratio that investors use to measure the amount of a company's income returned as shareholders equity. For us, when it comes to bank stocks, it's great when you see at least a 10% return on equity. So, really impressive to actually see JPMorgan at 15% return on equity last quarter. 

Return on assets was 1.37%. Return on assets shows how profitable a bank is relative to its total assets, and how efficient management is at using its assets to generate earnings. Generally speaking, we do like to see ROA at least 1%. 1.37% is even better.

Frankel: All three of those numbers were, like you said, by far the best out of the big four, efficiency ratio in particular. For these big banks, it's really tough to hit that 50% number that you were stating because there's so much overhead in terms of their branch networks, for one thing. They have to invest so much money just to be able to keep up with the new internet-based banks. It's really hard for them to get their expenses down. For a big brick and mortar-based bank, I always like to see under 60%. By that metric, JPMorgan is really performing well for such a big institution.

Jones: Absolutely. Looking ahead to earnings, would love to see that efficiency ratio continue to come down. Matt, you mentioned internet banks. I came across this last week and I said I had to talk about it. JPMorgan just launched an online bank for millennials named Finn. I don't know about you, Matt, but whoever's in charge of the naming conventions for a lot of these mobile-based apps, I must say, please let me in that seat. [laughs] I don't think you can get much worse than the name Finn. 

Basically, what Finn is, it's truly a mobile, no-fee checking and savings bank for millennials. You're talking about deposits by phone. You can even write a check by phone. Automatic saving, spending trackers, etcetera. It has a lot of the bells and whistles, although the interface looks pretty basic. 

What's interesting about this particular launch for Finn is that you see JPMorgan strategically positioning itself to grab market share in areas where there is no JPMorgan Chase bank branch, which I think is really interesting. It actually rolled out in St Louis, where they don't have any banks, and they're looking to continue to expand across the U.S. We'll really be looking to see how this competes with some of those other internet-based banks.

Frankel: That's true. It's really interesting to point out that, including the big four, there are very few banks, if any, that are all over the U.S. This could definitely help broaden their reach. What internet-based banking does, it also dramatically cuts down on a bank's costs. Not only do they not have to build branches in those markets you mentioned that they're not in, but they save money on things like paper costs, employees. A check deposited through a mobile app costs a bank roughly one-tenth of what a teller-assisted deposit costs. 

This ultimately can provide big cost advantages to banks, and help level the playing field with some of these up-and-comers that are offering free checking, free savings, better interest rates than everybody else because they don't have to pay for branches. This could help JPMorgan -- and, in time, some of the other big banks -- get a much more competitive advantage against these smaller players.

Jones: Yeah, absolutely. Speaking of technology, and even more so being impressed, that actually brings us to our second bank, which is Bank of America. They'll be reporting earnings on July 16th. I have to say, for me, Bank of America is probably one of the most impressive turnaround stories since the financial crisis. Matt, can you talk a little bit more about why that is and how they're making their money?

Frankel: Absolutely. In terms of these big four, they were kind of two categories they were in. JPMorgan and Wells Fargo made it through the financial crisis pretty much unscathed. They had their issues, but for the most part, they were pretty healthy and definitely emerged stronger than they went in, through mergers and acquisitions and things like that. Then, there were the banks that did really poorly because they had a ton of risky assets on their balance sheet. That was Bank of America and Citigroup. Bank of America has done by far, by far the best job of improving itself since the crisis.

To give you a number, Bank of America put out a 10.8% return on equity in the first quarter. That would have been unheard of a few years ago. Granted, tax reform helped a little bit with that, but for most of the past decade, Bank of America has not been profitable, let alone putting up numbers like that. Management has done a great job of turning it around. 

They actually beat the 10% return on equity benchmark, and 1% return on assets benchmark, for the first time in years. Their efficiency ratio is down to 60%, which is, like I said, what I look for for banks, which is even better than what Wells Fargo is, as we'll get to in a little bit. To say that Bank of America was more efficient than Wells Fargo a few years ago would have been a crazy statement. But Bank of America has done a great job turning itself around. 

The management team has been great about embracing technology. They've really emerged as a technological leader. It won the No. 1 mobile app out of all U.S. banks a few times. I think Global Finance Magazine was the one that gave them that award. Don't quote me on that. Anyway, they've done a great job of embracing technology. I think 25% of their transactions now come from their mobile app, which saves them a ton of money. It's allowed them to decrease their branch structure quicker than all of the other big competitors and really decrease expenses, improve efficiency. Management has done such a great job. 

The way I would sum that up, JPMorgan is the tried-and-true leader that has been doing everything right all along, and is really a well-run bank. If you want the industry leader, that's who you go for. Bank of America is actually in the late innings of a great turnaround story. We'll discuss valuation in a minute. If you want a company that's still valued like an up-and-comer, but is really starting to look like one of the best players in the industry, Bank of America is the one you want to look at.

Jones: I totally agree with you there, Matt. We'll talk about valuation, but I can already tell you, Bank of America is one of my top picks. JPMorgan, fairly easy to give a green light for. But I really love what BoA is doing. 

An addition for me, moving forward, things I'll be looking at is to continue to see Bank of America focus on expense management even more, especially with the technology that they're rolling out. 60% efficiency is good, it's headed in the right direction. Would love to see that even lower as they roll out new technology. 

But also, Bank of America has a higher than average concentration on non-interest-bearing deposits. In a rising rate environment, Bank of America actually stands to benefit more than some of the others as rates rise. 

I'll certainly be tapped into that for the bank. With the Feds hinting at one more rate hike in the second half of 2018, plus the likelihood of at least three rate hikes come 2019, I'm really curious to see how that plays out for Bank of America moving forward.

Frankel: Bank of America actually just came out and said that, for a 100-basis point, that's a 1% increase, in the (unclear 14:46), they were expecting a $3 billion increase in profit for every 1% interest rate increase. That could be a big catalyst going forward. You mentioned the non-interest deposits. To put a number behind that, out of Bank of America's $1.3 trillion deposit base, $450 billion of that is non-interest-bearing. To compare that, that's more than double what Citigroup has. Bank of America is in a great position to benefit as interest rates rise, more so than the other banks.

Jones: Lots to love with BoA there. With that, let's actually dive into our third bank, Citigroup. They are reporting earnings on July 13th. Matt, what can you tell us about how Citi does business?

Frankel: I mentioned that Citigroup and Bank of America were in the same pool coming out of the financial crisis. They both got crushed because of some bad assets on their balance sheet. While Bank of America has done a great job of rebounding, Citigroup has done an OK job of rebounding. I would call them the riskiest of the big four. Let's put that in context, though, because the others are rock-solid banks right now. 

There are two things that investors need to know. One, they're still working out what they call their legacy assets on their balance sheet. That's still a pretty big portion of their balance sheet. It's gotten much better over the years, but it's still there. Citigroup is by far, by far the most internationally exposed out of the big four. Not even close to the others. To give you an idea, 53% of their deposit base is international. JPMorgan, which a lot of people think of as a pretty international bank, is only 18% of international deposits. Bank of America is 6%. They're very internationally exposed, especially to some emerging markets that are not doing quite as well as the U.S. right now. That's where a lot of their risk comes from.

In terms of their business, they're structured pretty much the same as JPMorgan and Bank of America in terms of being a combination of commercial bank and investment bank, pretty much in the same proportions. 44% of their revenue comes from consumer banking, while 52% comes from investment banking and institutional sources.

In terms of profitability, as I mentioned, they've done a decent job of picking up their profitability. They're profitable. But not quite as good as Bank of America. Return on equity is 9.7% for the most recent quarter. That's shy of the 10% benchmark you want to see. Return on assets is 0.91%, short of that 1% benchmark. But, Citigroup has done a great job of becoming efficient. They run at a 58% efficiency ratio, which is actually the second best of the big four, to JPMorgan. 

It's kind of a mixed bag when it comes to the profitability and efficiency results. They've done a good job of rebounding, but there are still some big risk factors investors need to take into account before jumping into Citigroup.

Jones: Totally agree, I think you hit the nail on the head with the mixed bag. For me, heading into earnings, I love that they're at that 58% efficiency ratio. Like the others, would love to see continued expense management. I would love to see, too, if Citi can hit that 10% return on equity. 

I will say, you mentioned that they hit 9.7% in Q1 of this year. That was actually compared to 7.4% in the year prior. Definitely heading in the right direction. We'll see if they can finally get above that 10% threshold. Also, margins have been under pressure for the bank for a while. I'll also be watching that, as well.

That being said, let's actually talk about our last stock. Michael Douglass and I have chatted about this stock as well, we call it the problem child. There's probably no better term for it. Matt, let's talk about Wells Fargo. Can you tell us more about the business and, really, the burning question that I think most investors want to know is, have they finally turned a corner?

Frankel: We'll start with the business. Wells Fargo is the only one of the big four that is pretty much purely a commercial bank, as in they don't really engage in any investment banking activities. Even though they're such a big institution, their balance sheet looks like that of just a small savings-and-loan, just with much bigger numbers. They're primarily a commercial bank, and on paper, it looks pretty good. They're profitable. Return on equity is 12.3%, return on assets is 1.26%, so they're exceeding their benchmarks. Everything looks good in that respect.

But, if you've followed the financial news at all over the past couple of years, you know Wells Fargo's had some problems. They had their big fake accounts scandal, which came to light in September 2016, where it turns out they opened over three million unauthorized accounts. Over 5,000 Wells Fargo employees, to try to meet sales goals, behaved very badly. Since then, we've seen a string of, I call them mini-scandals, but they're really not that mini. They were overcharging people for mortgages, they were charging people for insurance on auto loans that really wasn't necessary. I was actually one of the people who got a notice that I was going to have to pay Wells Fargo auto insurance when I already had insurance somewhere else. It was a pain, but I cleared it up. A lot of customers just took them at their word that they needed this insurance.

Wells Fargo had a lot of bad stuff going for it. The thing that makes me say they're not out of the woods yet -- to be clear, they're doing a great job of trying to restore their image. Their annual report this year was actually called Rebuilding Trust, that was the title. You've probably seen some of the commercials -- Wells Fargo, reestablished in 2018. They're doing a great job of trying to clean up their image and make it clear to the public that their old ways are behind them. 

But the thing that really keeps me from saying they've turned the corner is that the Federal Reserve slapped them with this gigantic penalty that's never been done before that says, essentially, they can't grow until they've shown substantial improvement, is how the Fed put it. First of all, what does "substantial improvement" mean? It's a very vague term. There's no clear timetable when they will be allowed to grow, when the Fed will lift that penalty. The second thing, this is a bank that's not allowed to grow at arguably the best growth environment for banks in decades. 

Wells Fargo, on paper, looks like they're doing OK. Growth, they're not doing great. First quarter, their loan portfolio shrank, their deposit base shrank a little bit, revenues went down, while all the others grew in those areas. Like I said, they're not allowed to grow right now, so that probably has something to do with it. 

Wells Fargo is still great asset quality. They do a great job of risk management, always have. That's why they made it through the financial crisis in such great shape, and were able to scoop up Wachovia during the financial crisis, which was a game-changer for the bank. But, they behaved very badly, they got called on it, and they're still not out of the woods. 

I would need much more clarity from the Federal Reserve before I could give my endorsement to this stock, even though Warren Buffett has -- it's interesting to point out. He said it will be the best performer of the big four banks over the next decade. Take that for what it's worth. Some of us clearly disagree.

Jones: Hard to argue when the Fed taps your growth, in terms of being a real good investment opportunity. I'm with you on that. The main concern for me with Wells Fargo is -- like you brought up, Matt -- at what point is substantial improvement actually achieved in the eyes of the Fed? What does that look like? And, will Wells Fargo be able to regain the trust of its customer base enough to say that it can now comfortably grow over the long term and sustainably? Too many question marks on this stock for me. We'll have to wait and see if Buffett's words hold true.

With that, Matt, we've talked about the four big banks. Looking at it, three out of the four are doing well, winning where it matters most. You'd expect to see the market rewarding many of these bank stocks year-to-date, but it's actually been an interesting year. Can you talk a little bit more about that, and where these banks fall valuation-wise?

Frankel: Like you said, all four of them have actually gone down for the year. JPMorgan is pretty flat, but the rest of them -- Bank of America lost 2%. Wells Fargo is down 6% this year, some of that could be because the Fed penalty I just mentioned was imposed in February. Citigroup's down 8%. A lot of that is due to their international exposure. These have not performed well. A lot of it is because they've performed so well over the last few years, in the lead up to tax reform, the lead up to rising interest rates. It's almost like all that was priced in a little bit, so that's why they've underperformed this year. 

In terms of valuation, there are two things I'd like to highlight. One, the price to earnings multiple, while still useful, doesn't really tell you the whole story. For the most part, these banks trade in pretty much the same price to earnings range. Citigroup's a little cheaper, just because of the risk involved, but the rest are generally around 14-15X earnings. 

The real thing you want to look at is book value. Banks generally trade at a multiple of their assets depending on how profitable they are. That's how you can tell what you're getting for your money, what kind of quality you're getting for your money. To put that in context, JPMorgan is the most highly valued of the four, trades for just about 1.6X its book value. Bank of America is 1.2X book value. Wells Fargo is actually almost as much as JPMorgan, 1.55X its book value, just because of its high asset quality that I mentioned earlier. Citigroup is actually trading for below its book value, if that tells you anything about the risk you're taking on by buying that stock, it's about 96% of its book value. 

Then, you can even go a step further and look at what's called tangible book value, which only includes the assets that can be readily sold and you can really easily value. It excludes things like good will adjustments, things like that. Looking at it that way, Wells Fargo is actually the most expensive of the four at 2.1X its tangible book value, or 2.1X the value of its tangible assets on its balance sheet. Then it goes down from there. JPMorgan is 1.95X, Bank of America 1.75X its tangible book, and Citigroup is about 1.1X its tangible book. Big difference in those values that you really wouldn't see just by looking at the price to earnings multiple. 

It's really important to take that extra step when looking at these bank stocks. Price to book and price to tangible book really give you a feel for how much investors are willing to pay for these banks' assets. How well they generate profit on them generally dictates how valuable they're going to be from price to book. 

That's the metric you want to watch to see when it's a good time to buy. For example, if you love Bank of America, you might say, "I'll buy Bank of America if it's trading for less than its book value," which has happened many times in the past. That's the better metric than price to earnings that investors want to look at.

Jones: Of course, throughout this episode, we've been talking a lot about different bank metrics, what you should be looking for, and to your point, Matt, talking about price to earnings ratio vs. price to book, and even looking at tangible book value. For any listeners out there that really want an in-depth overview on those metrics, how to calculate them, how to compare them, we've actually have two really great resources. The first is an article entitled Your Complete Guide To Investing In Bank Stocks. Really great for beginners. Also, we have what we call the bank stock Bible around here, How I Analyze A Bank Stock, that's another one. If you are at all interested in snagging a copy of those, checking them out electronically, just email us at industryfocus@fool.com, and we'll get those to you.

To sum it all up, we've talked about the four big banks. Matt, you know my favorite right now is Bank of America. What's yours?

Frankel: Bank of America, I have to say. I wish I could be unique and go against you there, but I've owned Bank of America since right after the financial crisis. I wish the stock was still trading at the $10 per share I bought it at. As far as the valuation, compared with how well they're doing, how well they're growing and managing their expenses, it's really hard to pick one of the others. 

I will say, if you want to take more of a gamble on an up-and-coming bank that's trading really cheaply, Citigroup's probably worth a look. If you want, like I said, the best-in-breed, JPMorgan. I'd avoid Wells Fargo for the moment. Bank of America is my clear favorite of the four.

Jones: Nice. You've heard it from us here. Great ideas, great food for thought. That's it for this week's Financials' show. This month, The Motley Fool is turning 25. That's right, it's The Fool's 25th anniversary. To, celebrate, everything in the podcast swag store is 25% off. Just go to shop.fool.com and load up on all your podcast essentials between now and the end of July.

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 Shannon Jones. Thanks for listening and Fool on!

Matthew Frankel owns shares of AAPL and Bank of America. Shannon Jones has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends AAPL. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.