Personal Finance

The Simple Concept Underlying U.S. Bancorp's Dominance

Bar chart showing efficiency ratios of six big banks.

Even if you compare U.S. Bancorp (NYSE: USB) to the best in the banking business, it still dominates the competition. For seven consecutive years, it has ranked first among big banks in terms of return on equity, the preeminent profitability metric in the industry.

I've studied U.S. Bancorp over the years in an effort to figure out how it does this -- especially how it does so year in and year out. The short answer is that the Minneapolis-based bank is highly efficient, spending a smaller share of its revenue on operating expenses each year than even the notoriously efficient Wells Fargo .

Bar chart showing efficiency ratios of six big banks.

Data source: Quarterly earnings reports. Chart by author.

But there's more to U.S. Bancorp's perennial outperformance than just this. Efficiency is a necessary but not sufficient condition of dominance in the bank industry. A bank must be efficient to outperform its peers, in other words, but efficiency alone doesn't capture the whole picture. It instead merely ignites and accelerates what may best be described of as a force of nature, akin to the law of compounding returns.

Jim Collins in his book Good to Great analogizes this force of nature to a flywheel. It takes effort to get the wheel spinning, and more effort to make it go faster, but at a certain point, Collins notes, there's a breakthrough when the laws of physics take over:

The momentum of the thing kicks in in your favor, hurling the flywheel forward, turn after turn . . . whoosh! . . . its own heavy weight working for you. You're pushing no harder than during the first rotation, but the flywheel goes faster and faster. Each turn of the flywheel builds upon the work done earlier, compounding your investment of effort. A thousand times faster, then ten thousand, than a hundred thousand. The huge heavy disk flies forward, with almost unstoppable momentum.

No company illustrates the power of this concept better than , which, as Brad Stone writes in The Everything Store , incorporated Collins' flywheel into its operating philosophy more than a decade and a half ago.

In Amazon's version, a low-cost structure enables the e-commerce giant to offer lower prices than its competitors. Lower prices lead to happier customers, which leads to higher traffic on its website. Higher traffic encourages new sellers to join Amazon's marketplace, which increases selection. And a better selection improves the customer experience, which powers a new revolution of the flywheel.

Amazon's flywheel.

The Virtuous Cycle, as drawn by Amazon. Image source: Amazon.

Although Amazon and U.S. Bancorp are very different companies, the flywheel concept works in a similar way for the $446 billion bank. In fact, given the unique dynamics of banking, it may be an even more powerful force in the financial services arena.

By operating more efficiently than its peers, U.S. Bancorp can underprice them in the credit space. This attracts high-quality borrowers, boosting loan volumes and reducing loan losses. The latter keeps a lid on credit costs and thereby enables U.S. Bancorp to be even more competitive with respect to loan terms on the next revolution of the flywheel. It also buttresses the bank's debt rating, which keeps its interest expenses low and thus acts as added accelerant. Holding all else equal, then, with each turn of the flywheel, U.S. Bancorp should widen its competitive advantage over its peers.

This chain of events isn't just theoretical. Here's U.S. Bancorp Chairman and CEO Richard Davis connecting the dots between its low-cost debt and heightened pricing power on a conference call with analysts in 2015:

[Our best in class debt ratings] allow us to benefit from pricing. And again, this is an audience that understands this, but if we're going to the markets and we can receive five-year money at a 40 to 60 basis point benefit from our peer group, that's five years we get to price things better by 40% to 60% -- basis points and/or at least take half of it and put it into price. We only deal with high-quality customers, so we're not using it for subprime or near-prime purposes. We're using it for the best customers to win them and keep them, but we're unabashed about saying that we'll use pricing as a tool at this moment in time.

As I've demonstrated in the past , moreover, there's a clear correlation between efficiency ratios and loan losses among the nation's biggest banks. This follows from the fact that less efficient banks must stretch for yield in their loan portfolios in order to generate the double-digit returns on equity earned by more efficient banks. And because higher yields reflect higher risk, less efficient banks tend to write off a larger share of their loan portfolios during recessions such as the one following the financial crisis eight years ago.

A chart showing the relationship between efficiency and loan losses among big banks.

Data source: S&P Global Market Intelligence. Chart by author.

The irregular but not infrequent undulations of the credit cycle further accelerate this, as banks that play fast and loose with credit risk are more likely to fail when the economy takes a turn for the worse. And even short of insolvency, a bank that takes large loan losses in a downturn is in no position to pick up its less prudent peers for pennies on the dollar when they run into trouble, which is one of the most effective ways to grow a bank and maximize returns over the long run.

What all of this means is that U.S. Bancorp should continue to outperform its peers in the years ahead. Its stock isn't cheap, and Davis is retiring later this year, but I don't believe that either of these alter the investment thesis underlying its stock.

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John Maxfield owns shares of U.S. Bancorp and Wells Fargo. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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