Thoughts on bank stocks

I'm beginning to get really interested in bank stocks.  I wanted to articulate what I'm thinking about when I look at bank stocks.  The quality of a bank stock is easier to quantify*, although this ease can still cause mispricings since Mr. Market's recency bias cause him to sour on a bank's prospects beyond reason.  It also helps that the pendulum of public opinion is swinging very hard to extreme dislike for all banks.  In reality, a great bank is a really great business to own at the right price.

I recently finished The Most Important Thing by Howard Marks, which easily pushed its way to top of the list of my favorite books so far this year.  One of the overarching themes is that of the cycle.  Assets tend to become out of favor in their down cycles - homebuilders, banks, oil, chemicals - as a result of the pendulum really swinging to the negative extreme.  People tend to extrapolate current events into the future, so they think that the down cycle will continue and the relevant firms will continue to do poorly.  This is what creates a buying opportunity since the revulsion usually causes a bunch of selling which only encourages more selling, etc.  I don't think banks are the buy of the century right now, but I think they are a fertile ground to look for value as they are in a down cycle with poor outlooks.  I've been kicking around some ideas over the past week or two here and here, mainly focusing on mutual thrift conversion that have happened in the past few months.

David Tepper bought bank stocks at the brink, which turned out to be a phenomenal call.  He has since sold them and moved into homebuilders, probably not multibaggers in a matter of months like the banks were in 2009, but definitely an area where people are revolted and maybe not giving the stocks their fair value.  Bruce Berkowitz loaded up on financials about this time last year, although they seem to be around the same price +/- 15% depending on the name.  His reasoning:

We bought at prices reflecting pessimism in the economy. I do not believe that we are going to lose money at the prices we paid. If the economy just sputters along, we’ll do fine. If the economy recovers, we should do reasonably well. Absent a severe double-dip recession, I don’t see how our shareholders can get hurt.

When you buy something this out of favor, even the slightest bit of not bad news can be good news.  He is also focusing on the price, not nitpicking over credit card fee legislation.  This is a sensible outlook.  At least in my head, the cyclical forces that drive the banking business are very clear since it tends to mirror the broader economic cycle of the geography it serves.  Banks possess some identifiable characteristics that make for interesting investments in their own right.

1.  Essential service - Banks provide an essential service that will be difficult to change in the grand scheme.  Any type of financing allows people to purchase goods that would otherwise require huge upfront cash payments that don't match an individuals cash flow.  This is an essential service for people looking to own homes, cars, or for businesses wanting to expand faster without dilution.  Compared to other financing vehicles, banks are the low cost providers since their cost of funding is very low.  Even with financing consisting mostly of certificates of deposit, a bank's interest payments still fall below an equivalent financing vehicle without the same funding options.  This obviously changes in a credit bubble and banks can get sloppy as the lending environment becomes more competitive.

2.  Commodity business - There is no real superiority of a 6% plain vanilla loan from Bank A versus Bank B or even a nonbank financing entity.  For an investor though, behind the loan will be a difference in cost structure (efficiency ratio, net interest margin) as well as managerial competence (loan to value, non-performing loans, capital allocation) that are for the most part easily quantifiable.  Buffett's favorite bank, Wells Fargo, combines a low cost structure with managerial competence.  Its price goes down in bad times, but the bank never loses its enduring competitive advantage or normalized profitability.  This is no different from broad investing principles, but I find it easier to quantify these characteristics in a bank.  Banks are more susceptible to the depressive episodes of Mr. Market since a bad economy depresses loan growth and causes loans to sour.  The recency bias causes Mr. Market to really extrapolate out the bad times, but a calm investor can identify the cyclicality and wait for an attractive price (Berkowitz style).

3. Compounding machines - A good bank is compounding machine.  If a bank has a low cost structure and managerial competence, an investor can earn a lot of money if they purchase at the right price.  If you buy a bank that earns a normalized 12% ROE at 80% of book value, then you can earn a 15% return. The bank can either reinvest the profits in its loan book to continue to grow profits at a 12% ROE or it can return it to shareholders via dividends and share repurchases.  This can happen year after year if the bank has the right management at the helm.  The market for banking services is so huge that opportunities for reinvestment are a lot greater than say home builders or oil companies.

I think the ability to compound is what makes banks so interesting.  Most banks can't do it and the ones that have in the past are easily identified and rewarded with high multiples most of the time.  The smaller banks though are victims of the same inefficiencies  of small cap stocks in general though, so it makes for an interesting space to look.  A small bank beyond a minimum threshold is better suited to compounding too simply due to the law of large numbers.  Geographic concentration can expose you to specific risks, but it can also allow you to apply local knowledge if you live in the area.  You can also coattail on a better local economy (Dallas vs. Detroit) so it works both ways.

*It is easy, but still requires work.  It's certainly easier than figuring out the competitive advantage of a semiconductor company.  I like that I can go on the FDIC website and pull tons of figures and metrics into excel on an annual and quarterly basis and really dig into how the business has looked over a 10 year period.  You can overlay this with economic data to get a good feel on the performance of the bank, which is a lot easier than devoting hours to understand the product cycle of PC makers or really industry specific trends.  These posts on Value Uncovered do a good job in highlighting the specific investment process here and here and are well worth the time.