Can Banks Ever be Value Investments?
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Board: IV Stocks that Interest You
The question in the title refers to "banking operations" and not to various forms of fee-for-financial-services operations.
This follows a brief discussion on the First Marblehead (FMD) board - yes, I'm still a very (and now very, very) small shareholder of FMD. For what it's worth, investing in FMD right now is investing in the hope that the CEO and the bag of cash he still has will come up with a business idea. One possible idea is to become a small bank.
This made me think, "can bank's be value investments"? Nicholas Taleb was of the view that bank's frequently "blow up" so therefore they can't be victims of "Black Swans" - well, except to shareholders...and maybe elected officials...and maybe...
Leaving Taleb's Black Swans alone for the moment, I noticed when reading Ben Graham's Intelligent Investor (1973 edition) for the first time that in his chapters on the "conservative investor" and the "enterprising investor" he had exceptions in his criteria for utilities but nothing for banks. There's a comment about banks which is that, "We have no very helpful remarks to offer in [financial enterprises] other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied ... as we have suggested for industrial and public-utility investments", which is fine but if one applies those standards banks by and large just don't qualify - well, maybe if you don't consider deposits a form of debt. You might have trouble coming up with "tangible" book value too. Graham also states in the same section..."It is characteristic of all these [financial] enterprises that they have a relatively small part of their assets in the form of material things - such as fixed assets and merchandise inventories - but on the other hand most categories [of financial enterprises] have short-term obligations well in excess of their stock capital. The question of financial soundness is, therefore, more relevant here than in the case of the typical manufacturing or commercial enterprise. .... This, in turn, has given rise to various forms of regulation and supervision, with the design and general result of assuring against unsound financial practices." Well, maybe in 1973, they did.
It was with the Foolish Collective that I first tried evaluating banks - it's quite sometime ago. Jean Graham (LeKitKat) was still known as kitkatklub at the time. You can look up my attempts at evaluating Citigroup and Capital One here:
At that time I felt I could not trust "earnings" because I felt it was too easy to manipulate "earnings" by playing around with "reserves". I mistakenly thought that dividends were more stable. My thinking was that big banks wouldn't want to cut their dividends and therefore would be more cautious about what they paid out. It turns out that I was partly wrong - dividends can be cut or even eliminated and when re-instituted they'll likely be to shareholders who are different people than the original shareholders.
Now back to Taleb - why is this so?
Income statements are a statement of the revenue brought in for goods & services sold in a given period less the cost to produce and sell those goods & services. The costs to the bank are (1) interest paid to depositors, (2) costs to run facilities, pay employees, etc. and (3) costs of loans which might not (in the future) be paid back. The troubling bit is the last one because it's "in the future", which means sometimes we're just guessing; and since economies seem to have some strong long-wave (30-40 year) cycles there's a very big chance we'll be very, very wrong at least once every 30 years (about the lifetime of a mortgage). If we look at the evidence Taleb provides, we actually seem to get it wrong about once a decade, which isn't very encouraging.
The other problem with dividends is that back in 1990 "dividends" suddenly became bad and "growth" was all. So banks - even very big banks had to show that they were growth companies. While I agree that some growth is possible by using technology to be more efficient (i.e., reduce cost (2) above), it really should be very difficult for the banking industry to grow even at the rate of GDP growth. (High tech generally avoids debt financing and tends to be a big contributor to GDP growth - so if you back out high tech the GDP growth rate of companies and people that use debt should be lower - so my thinking goes anyway.) So, what's left...new markets, but if these are "new markets", that means markets banks have avoided because the risk is too high. That's okay we thought...if we package many high risk loans together and figure out the default rate, we can manage that risk....except....yup, long wave / 30-40 economic cycles which means it's impossible to collect enough relevant data to estimate what the default rate (e.g. how useful is 1970 student default rate data to 2011?). This is especially true if, due to shorter term data we think default rates across individual borrowers is uncorrelated when it turns out to be CORRELATED! Ooops! A financial "black swan" - or so bank executives would have us believe - who could have foreseen this? It was a black swan.
The trouble is the financial "black swan" is built into the business model - unless the bank is very, very conservative, which means (ugh!) a slow growth company; and which CEO wants to be the CEO of an ugly duckling, slow growth company.
Back to Graham's short comment in the "Intelligent Investor"....evaluating a bank as a "value" investment MUST include evaluating the soundness of the regulation and supervision of financial enterprises as well as the soundness of financial practices of the bank in question.
So, the answer to my question is, "sometimes - but only sometimes - yes". In the height of the financial crises when every bank was suspected of being insolvent, Canadian banks ended up being beaten down. However, the Canadian Office of the Superintendent of Financial Institutions (OSFI), was still very sound and the history of Canadian banks bleating that they should be free of the OSFI made me think that their financial practices were still not so bad. So I bought bank shares in the the Royal Bank, Toronto Dominion and Bank of Nova Scotia. This has been one of my better investment decisions.
But I don't expect to get a 2009 chance again for a long time....well, actually I hope to not get such a chance again...ever!