Wednesday, May 6, 2009

How to invest in banks

It is important for investors to not fight yesterday's battle. I am referring to financial and banking business. Considering all that has happened, it is tempting to avoid financial forever into future but that would be a mistake. Here is why.

1. Once the current crisis passes, banks will still be needed. Their business is ever green and needless to say is tied to economic growth. That is more true now that shadow banking has taken a hit.

2. It is likely that over next 5 or 10 years, banks will not repeat the past mistakes. This will mean banks will take prudent risks going forward and make loans to credit worthy customers. Eventually similar mistakes will be made, but that is not likely anytime soon.

3. There is less competition since some banks have gone out of business or acquired. The shadow banking system is out of business for most part.

4. My sense is that cost of credit will likely rise once government is out of the picture. I don't know when this will happen. But until then banks can make tons of money.

Now, some thoughts about basics of bank investment and what to look for.

1. First, one thing to learn from credit crisis is that it is important that financial be part of your portfolio and not the entire one. However, talented investor one may be, companies that operate with leverage is inherently risky. It depends on trust of others to lend money (customer deposits) and allow it to operate (regulator). So, limiting exposure (but not avoiding) is best for most investors.

2. A bank makes money by spread between the cost of money that it collects from depositors and the lending rate. I have a simple equation.

Profit = (lending or interest income) - (cost of money) - (cost of running a bank) - (loan losses) + Any fee income.

It is worth thinking about this for a minute. Mr. Buffet likes Wells Fargo because of it's ability to collect low cost deposits (cost of money). However, there is more to this. The variables in above equation are not independent. Here is why. Lets say two banks (Bank A and Bank B) have ability to collect deposits at 1.5% and 2.5% respectively. To get the same spread of 2.5%, Bank A would have to lend at 4% while Bank B would have to lend at 5%. Which of the two loans is more risky? The one at 5% is more risky than at 4% for obvious reasons. So loan losses for Bank B will be more than Bank A over a credit cycle thereby, making Bank A more profitable over the cycle. So low cost deposits are important, not only to reduce cost of raw material (cost of money) but also to reduce lending losses.

3. Find a CEO who has a clearly articulated simple strategy and will not follow the crowd. This is key since banks invariably get into trouble in the same area once every two decades. Usually, in an area that creates lot of profits before the bubble bursts.

4. CEO must be in control of the show and must be the chief risk officer. It is true that getting to know the bank management is not an easy job for small investor. However, downturns provide an excellent opportunity to evaluate their past actions. It is not difficult to infer that JP Morgan and Wells Fargo had better managements than few other big banks. So study their record in down markets and likely there is no better way to evaluate their past actions.

5. Prefer a bank that attempts to grow organically and not by big acquisitions. In particular, it is best to avoid merger of equals. Targeted acquisition of a small bank works better. In this downturn, acquisitions have been opportunistic and I think in all most all cases, the acuiring company may have been better off without those. Some exceptions do exist. As Jammie Dimon (JP Morgan CEO) replied in an interview about why he only agreed to pay $2 for Bear Stearns initially. He said there is a difference between buying a home and buying a home that is burning. That illustrates the risks in quick opportunistic acquisitions.

6. Costs do matter. Since banks are commodity business, cost of running the bank is important. Lower the better. All things being equal, lower the cost of running a bank, lower the risk bank needs to take to earn the same spread.

Finally, all things said, consider banks that focus on profitability than growth. Focus on those that take thoughtful credit risks and never tries to loosen on credit standards. Focus on cost of running a bank. Last but possibly most important, never buy if you do not have a sense of the management capability and temperment to avoid profitable (in short term) but risky ventures.

Good luck and leave your comments.