Wednesday, August 18, 2010

Value Investing In Banks

I often get asked if I 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. The dividend cuts that have taken place throughout this downturn have proven how susceptible this strategy is to an erosion of principal.

Are there circumstances under which I would 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.


Paul said...

I totally agree with this. I believe a lot of value investors thought they knew about how to evaluate the banks, but in reality, there were very much off the mark. Many great firms lost a ton of money for their clients by investing in banks at the exactly wrong time, like Dodge and Cox, Davis Advisors, etc.

Ankit Gupta said...

Agreed on this - one part that bothers me is their accounting, it's just not something I'm good at understanding. Specifically, they setup accounts for loan loss reserves. Going into the downturn, they were limited on how much they could put in there because it can mask earnings and decrease their taxes. If they put too little, earnings are amplified and false.

A lot of banks have been doing really well on the income statement and it might be because they were decreasing the accounts for loan loss reserves. I'm not someone with the knowledge to judge that and so I avoid it entirely.

If I did make a play, it would probably be in the bonds just because it's much closer to the value.

Unknown said...

Banks just have too many complex "products." Lets be honest, if people really understood how banks ran, we may have avoided the most recent market collapse. And why are banks the source of soo many economic collapses? The holdings company in the 1920s where companies layered themselves and had debt at each layer. Then 1980s Ibanks and bond bubble. Now the housing bubble.

Unknown said...

I've avoided the big banks for circle of competence reasons, both before and after the crisis.

I do think there are occasions where an amateur (such as myself) can value a small bank. I was confident enough of my analysis of CZFS to make it my largest holding (of about 20 holdings) when I bought into it post-crisis.

Essentially, what set this small bank apart from other small banks was

1) Its ratios merely looked cheap, not super-cheap. Its P/E was around 7, while many of its peers had P/Es below 5 (if they were profitable at all). Its P/B was 1.2 or 1.3, while its peers often sold well below book.

2) Unlike most other banks, it was not hurt by the crisis. There were several clues to this. The bank was turning in record profits. Non-performing-assets were not rising. The bank refused TARP funds. The bank raised its dividend while many others were cutting theirs. Insiders were purchasing stock.

3) The bank was helped by the response to the crisis. Plunging interest rates sent its net interest margins higher, even though it was doing fine already. It also appeared to be attracting lots of deposits, perhaps withdrawn from shakier institutions.

Perhaps most important, the solidity of CZFS under crisis showed the quality and conservatism of its management. CZFS is still one of my largest holdings, although its not as cheap as it was.