Banks Are Black Boxes (Or Are They?)

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“It’s very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt. At the same time, you have to see the new debt that’s coming in, the new loans that they’re giving out. It’s fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio. So it’s just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans?”

―Bruce Berkowitz on Citigroup investment

Unlike Bruce Berkowitz’ insightful observation above, the response of many other investors at the mention of a bank as a potential investment goes something like this: “It’s a black box. Too much risk. I don’t understand banks”. The recent financial crisis has negatively impacted the perception of banks and revealed hidden “spider webs” in the financial statements. However, a good checklist tailored to bank investments should prove a useful tool in rationalizing the investment decision for potential bank investments and help reduce mistakes related to investing in banks.

Our checklist is based on our analysis of banks and includes past mistakes of great investors including Warren Buffett, Bruce Berkowitz and Peter Lynch. The checklist focuses on the four pillars of our investment analysis: 1) sustainability of the business model, 2) accountability of the management, 3) value of the investment, and 4) risk factors, i.e. business/emotional risk and leverage. While no business will pass the checklist with a perfect mark, the goal is to show the pitfalls and potentially avoid permanent loss of capital.

The banking industry has a key structural advantage in consolidation. In the U.S., it’s likely that a household utilizes services of either Bank of America, Wells Fargo, Citigroup, or JPMorgan Chase. A centuries old business model, banking continues to thrive. Banks profit by lending at higher rates and paying depositors lower rates. The spread is called net interest income. Revenue from fees and other services is called non-interest income. Both combine to total net revenue. Management is mainly responsible for undertaking risk and should be evaluated carefully.

A bank is a business similar to any other. Aside from a few select variables listed below, similar rules of intelligent investing apply. The sustainability of the bank’s business model is impacted by cost and scale. Accountability should be heavily in focus. How is the track record of the management with regards to growth in earnings and profitable lending? Is the bank growing its earnings at a healthy pace? Value is better understood by comparing book value to the return on equity. How does the value compare to peers? When considering risk, how strong is the bank’s balance sheet? Banks have three types of risk: 1) credit risk, 2) interest rate risk, and 3) liquidity risk.

In an economic downturn it helps to pay attention to the “normalized” earnings power of the bank without provisions for loan losses. Eventually, the normalized earnings will start to show on the financial statements as the recession recedes and new, healthier loans overtake the previous bad lending.

Examples from the Checklist

Business Model

What is the bank’s cost-to-income ratio vs. peers? Cost/income ratio is the ratio derived from operating expenses and operating income. The ratio measures the proportion of bank’s income that is consumed by operating costs. It is a key performance indicator of a bank’s efficiency. The smaller the ratio, the more efficient is the bank.

Management

Have I analyzed for quality of the management? What is the rate of insider ownership? This is the most important area for banks, as management is responsible for risk-taking.

Value

What is earnings per share power after provisioning for potential loan losses?

Risk

bank investing checklistCommercial loans are more risky than others. What percentage of the loans outstanding are commercial? Ensure it’s below 10% or else there could be the potential for a large disappointment.

These and many other factors are discussed in our 35+ item checklist for analyzing a bank.


Checklists are also a topic at Best Ideas 2014 and were covered in Jason Zweig’s column in The Wall Street Journal.

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