Thursday, September 17, 2009

Banks And Value Investing

We often get asked if we see value in some banks at these price levels. Some value investors purport to be able to value banks. Some may actually be able to, while others may only think they are able to. For the average retail investor, however, it is just too difficult to determine the intrinsic values of these "black boxes", for several reasons.

First of all, determining the value of the assets of these institutions is a guess at best, without a deep understanding of the bank's loan portfolio. As we've discussed before, some businesses are easier to understand than others. With the complex behemoths banks have become, their business models are very difficult to understand. I can't honestly say that they fall within my circle of competence.

But even if one could determine what the assets are worth to some range of values, the amount of leverage used by the banks seriously clouds the value of the equity. For example, for Bank A, you may believe the assets are worth $10,000 plus or minus 10%; but if Bank A uses $9000 in debt to fund those assets, the remaining equity value could be anywhere from $0 to $2000. As long as the shares trade in that range, you have no idea if you're buying at a discount to intrinsic value.

Needless to say, the high debt levels used by banks also make them much more susceptible to collapse during downturns, which is a phenomenon we are seeing right now. Value investors much prefer companies with low debt as they have much greater power to weather downturns.

Though many banks have been offering high dividend yields of late, it's extremely important to understand where that dividend is coming from in order to attain reasonable assurance that it is sustainable. Buying blindly for dividend yield is not an option.

Are there circumstances under which we could buy banks? Certainly. Under a situation where the entire industry is undervalued for example, a purchase of a basket of several banks helps diversify away the risk of failures here and there. This is a similar situation to our approach on pharmaceuticals, where large amounts of research money are being spent, but it's unclear which companies will reap the rewards.

The bottom line is, buying individual banks is a risk unless you understand the value of what it is you're buying. Buying because stocks are down, or because momentum is up, or because yields are high does not adequately protect your capital.

5 comments:

prince said...

Saj,
Another great article. What not to do is often as valuable as what to do.

One good thing about banks for investors(from my VERY limited perspective) is that as consumer banking costs have decreased (use of ATMS for cash and debit cards for purchases) the costs they charge have not, thus I would assume that such profit goes to the bank.

My question is, would you view a local bank in a real estate market that avoided the the hype and crash(say Boise or Buffalo) and yet has also been abandoned for being part of financials. I.e despite the now weekly FDIC bank shutdown announcements in the WSJ, would you look for a margin of safety in a small local bank?

Thanks again for a great site?

Saj Karsan said...

Hi Prince,

The banks you describe may have been punished unfairly by the market, which may offer an opportunity as you say. For me personally, though, the issue of circle of competence still applies. With so much leverage (which is a characteristic of the banking industry), and without a handle on the value of the assets, I'd be hard-pressed to be able to determine that there IS a margin of safety. For someone who can though, I would totally agree that the area you describe has potential for gains.

prince said...

Sorry that was an exclamation point not question mark after great site!

I think you're right, hard to tell who's good banks and from mediocre ones without viewing their books. Interestingly, the journal had this today
http://online.wsj.com/article/SB125331196488624031.html#mod=WSJ_hps_LEFTWhatsNews

Indiana? Kentucky? wow!

Btw I found your site months ago when I was analyzing NGA and found that we agreed on the company. What do you think of them lately?

Saj Karsan said...

Hi Prince,

I haven't really followed NGA since the article you refer to. Have they fundamentally changed how they do business? If not, for me nothing has changed, as the company's future is too unpredictable for me.

KP said...

Bank investing is indeed very tricky, but the opaqueness of the industry can also give rise to great opportunities. As with many value investments, find the best players in the industry and be patient until the risk-reward is extremely compelling. JP Morgan was an example of such an opportunity. Can you tell exactly what's the value of its book or assess its exposures? No way. Still, you know its the pre-eminent US bank, it will grow through the cycle, it weathered the worst crisis since the Great Depression without big problems (took only $0.25 in core losses!), and it can earn $5-6. The market gave you an opportunity to buy this company at $30, after raising all the capital that it needed and reaching very high capitalization levels. Looking at a bank balance sheet under a microscope can be scary, but abstracting somewhat from it can produce opportunities that make a lot of sense.

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