3 Lessons Every Bank Investor Should Learn From This Bank’s Record Setting 2015

First Republic Bank is a great case study for conservative, long-term, and lucrative bank stock investing.

Jay Jenkins
Jay Jenkins
Feb 6, 2016 at 11:33AM

Since buying First Republic Bank (NYSE:FRC) back from Bank of America five and a half years ago, CEO Jim Herbert and his team have delivered core earnings-per-share growth of 16% per year. Tangible book value per share has also grown at a 16% compounded annual growth rate. Over the past five years, the stock has beaten the S&P 500 by 2.7 times. In 2015, the company reported its best ever numbers for both revenue and earnings. 

How do they do it? Herbert lays it out as clearly as one could want. He told investors on the company's fourth quarter conference call that the "bottom line is that we're focused as ever on the key pillars of our model: strong capital and liquidity, excellent credit quality, and exceptional client service.

The Jim Herbert philosophy of banking simply works. Let's break down these three pillars into digestible pieces and talk about what each means for bottom line results.

1. A strong foundation is a powerful tool
The markets have been pretty scary so far in 2016. Volatility has been high, fear has gripped investor thinking, and there are concerns about the health of the broader economy. First Republic counters moments like these by building the bank on a robust capital foundation. Herbert explained to analysts on the fourth-quarter call:

If you go back for 30 years, we stay well capitalized. Stuff happens-the world gets nervous, the world blows up, and if you don't have capital going into that moment, you're in big trouble. If you do have it, you have a great opportunity.

Currently, First Republic has a common equity tier 1 ratio of 10.76%, well above the regulatory threshold necessary to be considered well capitalized (6.5%).

By being well capitalized, a bank has two primary advantages over lesser capitalized institutions in times of turmoil. First, the higher capitalization protects the bank from losses. That makes it easier to deal with problem assets, reduces regulator intervention into the bank's affairs, and lowers the risk of an outright bank failure.

Second, and perhaps more importantly, a strong capital base allows the bank to continue investing during tough times. That's a huge advantage. It could mean strategic acquisitions of weaker banks like the deals that propelled JPMorgan Chase and Wells Fargo to the top of the banking elite during and after the financial crisis. In 2008 alone, these two banks grew total assets 39% and 128%, respectively, via major acquisitions of weakened competitors. Those acquisitions have continued to pay dividends for JPMorgan and Wells, and they were only possible because of their excellent capital bases.

It could also mean by continuing to lend to the best customers in a given market place. When you are able to lend when no one else can, it instills loyalty in your existing client base and can drive sizable market share growth.

2. Excellent credit quality
From an operating perspective, First Republic puts credit quality above all else. The bank's typical loan-to-value ratio on commercial real estate is 51%. That's 34% lower than the FDIC's guidelines for loan-to-value limits. The bank's typical home loan has a loan-to-value ratio of just 60%, meaning that the bank's customers have upwards of 40% of the home's value invested upfront as a down payment. The bank's median mortgage customer has a credit score of 773.

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Credit standards like these will, over the long term, be a huge boost to earnings and capital growth thanks to lower loan losses in down markets. Since 1985, First Republic has written off only 0.22% of the $144.2 billion in loans invested over that 30-year period. Over that same period, all FDIC insured institutions have averaged 0.92%, over four times more than First Republic.

The importance of credit quality makes perfect sense when you step back to think more generally about the banking business. Banks make money by lending money, charging interest on that loan, and then collecting both interest and principal over time. To profit, the bank must collect the interest due. To survive it must collect the principal. Excellent credit quality ensures both.

3. Deliver exceptional customer service (and stick to who you are)
On the fourth quarter conference call, Herbert said, "we continue to succeed because we remain completely focused on delivering exceptional client service through a very simple business model that offers stability and predictability."

First Republic knows what it is as an institution, it knows what drives its success, and it sticks to it. Its business model is designed so that clients have a single point of contact for all of their banking needs. A banker who knows them personally and understands not just their finances, but their motivations, goals, and needs. Surrounding that single point of contact is a team of bankers specializing in various products, from mortgages to deposits to wealth management, insurance, and loans. This organizational structure drives a white glove service that its clients simply can't get from other financial institutions.

Further, the bank knows that the driver of its successes over the years has been its conservatism and its client first culture. That self-awareness keeps the bank from veering away from its core advantages and into uncharted and dangerous waters. How many banks followed the crowd into sub-prime lending leading up the financial crisis? And how many of those banks suffered huge losses, or possibly even failed entirely? First Republic did not go down the subprime path because it knows what it is and it sticks to what it knows.

For example, an analyst asked Herbert his thoughts on the success the bank has had gathering deposits from the tech industry in and around Silicon Valley this year. Instead of talking about the huge growth opportunity and steering the bank into this new arena full steam ahead, Herbert instead took this opportunity to instead explain what the bank was not going to do. He said: "We have had considerable success ... in the technology deposit area, and I emphasize deposits. We're not lending to high tech companies-that's Silicon Valley Bank's business."

First Republic knows what it is, and it does what it knows
Not every bank is built to do business like First Republic. Megabanks such as JPMorgan and Wells Fargo are vastly larger, with sprawling empires that touch almost every part of the financial world. That's fine for them, but that is not the path for First Republic. This is a bank built on the philosophies of CEO Jim Herbert, where conservatism, simplicity, and customer service matter more than all else. It's a bank that's done well in the good times and the bad, and for bank investors every where, it's a bank worth paying attention to.