Wednesday, February 20, 2013

A banking primer

Value investors come in two types, the ones who will look at financials, and the ones who won't.  If banking is your forte I would encourage you to read the paragraph on my approach then come back for my next post.  If banking is intimidating or difficult to understand hopefully this post will be educational and break bank investing down into easy to understand pieces.  The bank I use as an example is not a good investment, but I'll cover why.  I think readers will understand how to analyze a bank better by understanding what's bad about banks instead of showing a perfect banking investment.  If anyone thinks I'm long winded something to consider; this post is based off a presentation I gave to my company and I covered this material in under four minutes, I can condense when I need to.

Approach

My approach to bank investing is very similar to my approach to buying any other cheap stock.  I prefer to buy banks at 2/3 of tangible book value and sell when they approach 1x tangible book value.  There are many banks trading at or above tangible book value, and a bank that's profitable should be trading above it, yet many don't.  A lot of stocks trade below TBV due to management mis-deeds, or the inability of a company to earn their cost of capital.  I believe the reason for bank cheapness now is different, we just went through a banking crisis and banks are still considered toxic investments.  Beyond this the market has lost interest in smaller community banks conduct the boring business of gathering assets and re-loaning the money.  Many of these community banks emerged from the crisis unscathed, and in a lot of cases overcapitalized and trading at incredibly low valuations.  Unfortunately market psychology doesn't care much about this, the banks are still considered risky.

Banking basics

Banking is the ultimate commodity business, and at the same time the ultimate niche/moat business as well.  At the most basic level banks are all the same, they take in deposits and loan against those deposits making a spread.  Banks have the ability to work at the edges, but the fundamental business is the exact same for a bank in Peoria Illinois as it is for a bank in Sevilla Spain.

Banks are very simple, they gather money in the form of deposits then they loan that money back to those same people and collect interest on the loans.  Bank financial statements are a bit strange to look at because we think in terms of ourselves most often.  A person's asset might be cash, which deposited at a bank is a liability.  A liability to a person such as an auto loan is an asset to a bank.  The assets and liabilities are flipped from what you are used to seeing on a normal financial statement.  The good news is you only need to learn this once, all banks report in the same manner.

One thing that's interesting about banking is how sticky customers are.  For how commodity the bank industry is many banks have what might be considered a moat.  Bank switching costs are high, it's very difficult to open and close an account, and most customers don't consider it worth the hassle.  I opened an account at a bank a few months back and took my son with me thinking it would be a quick errand.  He's three years old, I could count the time it took to open the account by the number of Dum-Dums he ate while waiting, hint his mother will never know the true tally.  I think from start to finish it was about 45 minutes, that time alone is an impediment for customers to switch accounts, not to mention having to switch billpay and auto-draft numbers.

Introducing Atlantic Bancshares

The bank in this example is Atlantic Bancshares (ATBA), which is a tiny bank located in South Carolina.  The bank has some issues with bad loans which you'll see in a few minutes, but the valuation is attractive.  The bank has equity of $7.2m and is currently trading with a market value of $1.4m, or 19% of book value.  The bank publishes their annual reports on their website, with the most recent update from the summer.  I'm going to use last year's annual report for this example, it's a little outdated, but it doesn't matter much, the principles are universal.

The balance sheet

Assets

Here is the bank's balance sheet as it appears in the annual report:

The structure of any company's balance sheet is important, small differences on the balance sheet can mean the difference between profit and loss.

Starting at the top the first thing you'll notice is cash and cash due from other banks.  Banks hold cash and securities against their regulatory capital requirements.  An item worth noting with this bank is they have a lot of cash but not many marketable securities.  The cash is earning them nothing, where securities might be earning something.  Securities are counted against capital differently than cash, which can drive the composition, all things being equal interest bearing securities are better than cash.

The next important number is "Loans Receivable", in this case the bank has $64m in loans, or 69% of their assets are loans.  In the notes the bank breaks down their loans into the following categories:

Different investors have different opinions on what the best loan makeup is, but there are a few things to keep in mind.  Residential loans have the longest duration meaning a bank is locking in a residential loan rate for a longer term, usually 15 or 30 years.  On the other hand construction and development loans which might have a shorter maturity are much riskier.  Commercial loans carry higher rates than residential loans, but have risks as well.  Residential loans are usually made in smaller sizes, $100k, $300k etc.  Commercial lending is usually in larger amounts, if a commercial loan goes bad one loan could mean a few million dollars in losses, whereas a residential loan might only be a few hundred thousand dollars in losses.

The final lines under assets include bank owned real estate, and any assets related to branches they might own or lease.  The number under owned real estate is important to watch, banks are in the business of lending money, not managing properties.  A large number here might indicate the bank is a poor lender and underwrote a number of bad loans.

Liabilities

I like to scan a bank's liabilities first when initially looking at an investment.  A banks funding base is the first indication of profitability.  The ideal bank setup is one where the funding base is non-interest bearing deposits that can be re-loaned at much higher rates.  Commercial lending falls under this category, most businesses that borrow from banks are required to keep large deposits in order to secure a credit line.  To break this down a company might deposit $500k at a bank and receive no interest on their deposit.  The bank then lends the business $1,000,000 at 8% on a credit line.  In essence the bank is making the business pay 8% on their initial $500k to gain access to the second $500k.  

In Atlantic Bancshares' case only 27% of their funding comes from non-interest bearing deposits.  As one walks down the categories of deposits the deposits become more costly.  An interest-bearing checking account might pay a small amount of interest whereas a CD pays a might higher interest rate.  You'll notice that most of Atlantic's funding comes from interest bearing sources, money market accounts, and CDs.  

The more interest the bank pays out to depositors the less money available for shareholders.  Finding banks with low cost funding structures is important.

The final item to look at on the balance sheet is the capital structure.  Atlantic Bancshares has a 7.37% equity ratio (equity/total assets), this means the bank is undercapitalized and will at some point require a further capital injection.  They did a recent preferred issue in 2011 which is seen under the Series AAA heading.  The bank raised $1.4m in 2011, mostly from directors and existing shareholders.

If anyone is trying to understand why this bank is a bad investment the capital structure coupled with the losses is the answer.  The bank is going to need to undertake costly dilutive preferred or equity offerings in order to meet their regulatory capital requirements.  As the bank continues to lose money the capital ratio will continue to deteriorate, until something changes the outlook is dire.

Income statement

Here is the bank's income statement:


The income statement is where we see the interest mechanics at work.  The bank took in $4.4m in gross interest from loans and interest paid on their marketable securities.  They paid out $1.08m to depositors holding CDs and money market accounts.  The bank then earmarked $1.86m as a provision for loan losses.  This means the bank is expecting to lose $1.86m or more on loans and they're saving this money ahead of time to deal with the problem.

After the bank pays out its depositors, and provisions for losses they are left with their net interest income.  After that is non-interest income, this is where things like overdrafts and one time investment gains are classified.  When you re-order checks and are surprised to learn they cost $24 that fee appears in this category on the bank's financial statement.

The net interest income plus other income is a sort of gross profit for banks.  Out of the remainder the bank pays for operations including salaries, rent, and other costs of doing business.  Following those expenses the bank pays taxes if they made a profit and records their profit or loss.

Some investors like to look at what is considered core banking earning power using pre-tax, pre-provision earnings.  For Atlantic Bancshares in 2011 their PTPP earnings would have been $503,843, meaning the shares are trading at ~3x PTPP.

Compared to the balance sheet a bank's income statement is very straightforward.  Expenses are itemized at a detail level that's unusual for a non-financial company.  What I like about the income statement is it clearly shows the drivers for a bank's profitability.  A few quick calculations can be made, take the interest from loans and divide it by the loans outstanding and you can see the interest rate on the bank's loans.  Take interest expense and divide it by deposits to see what the bank's paying on deposits.

Most of a bank's profitability hinges on two components, their expense management, and their interest margin.  If the net interest margin is too small because they have a high cost funding base they will struggle to maintain profitability.  Likewise if the bank's expenses are out of control there will be no profit left for shareholders.

Concluding thoughts

Astute readers will note I left out two things, a discussion of loan losses, and any discussion of a cash flow statement.  The cash flow statement isn't as useful when analyzing banks as it when analyzing a non-financial.  In a non-financial cash flows can be used to ferret out fraud, for banks other measures need to be used.  Banking fraud does happen, but it requires a bit more ingenuity because banks are so highly regulated.  The biggest risk to a bank investment isn't fraud but stupidity.  If a bank gets lazy and starts writing loose loans they will sink from lax lending standards quicker than anything else.

The second point is much more important, the banks loan losses and trend of losses is vital in determining the safety of an investment.  If the bank has too many non-performing loans they will either fail or be required to raise capital.  The level of NPA's is important, but the trend is just as important.  I didn't touch on this in too much detail because this isn't a comprehensive banking guide, different investors have different NPA preferences, I prefer lower and safer amounts, but some people do well riding momentum as losses start to moderate.

I hope this post has been helpful in explaining bank investing at an entry level.  There are a variety of resources to learn about each aspect of banking at a deeper level, but there is no substitute for practice.  The best way to learn how to value banks is to get out there and start valuing.

Talk to Nate about bank investing

Disclosure: No position in Atlantic Bancshares

34 comments:

  1. Very interesting. I usually shy away from investing in banks, usually because investment banking arms make the balance sheets almost impossible to assess for safety, but I may look for some opportunities in the traditional banks.

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    1. Yes, community banks are completely different than investment or large multi-national banks with complicated balance sheets. These are the Wonderful Life types of banks, bread and butter deposits and lending.

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  2. Nice bank valuation 101 Nate.

    Do you have more good sources for "layman", books or otherwise, which you could recommend if one would be interested to learn more about banking as a business?

    Technical question:
    Doesn't the 1.86 m. provision mean that they essentially write down the loan receivable in the balance sheet to an amount they expect they really can collect?

    So they don't actually move("earmark") cash to some special account that restricts its use to other purposes?



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    1. There's a book floating out there called "Analyzing and Investing in Community Banks" it's a PDF, at one point it was on the author's website for download. The book is dated the the concepts still apply.

      I think you're right about the provision, but need to look into it further.

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    2. Thx for the book tip - exactly what I was hoping to find!

      I looked a bit in to the provision thing an it seems that it can also be "money moved on the sidelines", but usually its just contra entry in the income statement when one adds more to the loan loss reserve in the balance sheet.

      Write down is different thing.

      Link below was helpful for me...

      http://www.nw.org/network/documents/7-LoanLossAcctg.pdf

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    3. Hey Nate, you know, I think I've read that PDF too and I remember where -- it's in CSInvesting.org's eLibrary. John Chew is awesome.

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    4. I would encourage you to spend some more time analyzing loan loss provision. In Nate's example it was mostly a cash charge. $1.8 million provision but only a $0.4 increase in loan loss reserve. Thus $1.4 million was actual cash loss incurred. In his example the bank is grossly under reserved (just 1.1% at the end of 2010 but increased to 1.9% at end of 2011). You need to compare the reserve to NPA (non performing assets). Some banks are quick to reserve while others are very slow. The slow ones are over stating earnings.

      I don't know if they still publish, but Vulture's Roost does an excellent job covering community banks and their work is very enjoyable to read. Their community bank primer is worth getting your hands on.

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  3. If you're interested in banks, you might take a look at Eastern Virginia Bankshares (EVBS). It was really cheap a few months ago and still trades well below tangible book.

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  4. Thanks for this, I've been looking for this type of beginner guide for a while now.

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  5. Nice post, Nate, always good to go back to basics - gee, I almost feel like buying a bank now! But seriously, despite my oft-repeated avoidance of investing in banks, local banks are a completely different kettle of fish & possibly an investment goldmine.

    I could spend a year researching this sector, but where to start... And really we're just talking about the US, unfortunately this sector is horribly under-represented in other listed markets.

    btw Cambridge just bought 50% of a small UK bank! Probably a first for an endowment investment...

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  6. Hi Nate,

    A good primer.

    These may interest you if you look beyond retail banking and get into mega-banks with investment arms:-

    Start with this: http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/

    And then this: http://brontecapital.blogspot.com.au/2011/08/bank-of-america-time-everyone-took-long.html

    p.s. The specific issues scrutinized in The Altantic piece were way out of proportion. But I found it set the perspective right when one looks at mega-banks.

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    1. I'd read both of those pieces, both good. Megabanks are tough because the balance sheets are hard to understand. They're simple line items but it's a question of what's behind those line items, even people at the companies don't know in detail because there is so much. $500m in home loans is different than billions in securities.

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  7. You can check CRCAM which are Caisse Regionale du Credit Agricole in France. You have for each region a Caisse Regionale which is a classic deposit bank for a part of France such as Languedoc Roussillon or Morbihan. I'm sure you can still find value with very nice dividend yield currently.
    Check CRAV, CRAP for example.

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    1. I have looked at the Caisse Regionalles before, many times actually. Maybe I should post on them, they're trading at crazy valuations with high dividend yields. My concern is I really have no idea if French real estate is inflated or not, what happens if they take a hit and the quality of loans.

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  8. Yes, I've noticed the Caisse/Credit Agricole banks - at first glance, their websites are not that investor or English friendly..! But I will be taking a further trawl through them at some point.

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  9. Nate:

    Good article, as usual. HOWEVER, don't you think the "easy money" has already been made in the bank stocks?

    Actually, I've been selling some of my positions...

    Right now, I think the small community banks are starting to earn normal returns on their assets.

    One bank I bought in Nov/Dec 2011 at prices around 2.5 share. Book value then was about $9/share. They had some bad loans and problems with a small division, so they were LOSING money for the TTM. HOWEVER, their large charge was almost 1 year ago, so that was going to drop off in a couple of months...

    Fast forward to today...the price is just above $8/share and the bank is earning $.99 TTM. They also had their consent decree rescinded. I think this pave the way for resumption of future dividends.

    The interesting thing though is that "cash flow" is very relevant for this bank. They spent a bunch of money (foolishly in hindsight) buying out truly tiny competitors...So they've got a bunch of goodwill & intangibles. They are slow amortizing this...Thus, their true "CASH" earnings are actually about $1.14/share. There are a good amount of banks that have amortization of intangibles and thus have higher cash flow.

    Almost forgot to mention, this bank is RBNF.

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    1. Yes and no, so the easy money in banks was like the easy money in stocks in 2009, we aren't 2009 for community banks anymore, but I think we're still in 2010.

      The near death banks that survived have sprung back like you've mentioned. There are still plenty of lower earning power banks with decent businesses trading below book.

      Good point on cash flow too. This is a great post, you looked through the mess and saw a lot of value, and you were aptly rewarded for it.

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    2. Nate:

      Thank you, Jeff over at "Ragnar is a Pirate" was kind enough to let me post my thoughts (as a guest commentator) on RBNF over a year ago.

      Lane Sigurd at "Reminiscences of a Stockblogger" has also done a tremendous job researching and writing about RNBF.

      I would like to add a few more thoughts on community banks.

      A). One of the fertile grounds I found was the FDIC directed take overs, especially in the early days. The banks that were taking over failed banks were sometimes "lead pipe cinches". The FDIC is not going to let a "sick" bank acquire another one. Often, the takeover terms were EXTREMELY favorable. The government was concerned about continuity and stability in the banking system. They were not concerned about minimizing losses for the taxpayer....

      B). TEXAS RATIO....a quick & dirty way to eliminate potential investments.

      C). There are all sorts of quirks that can be found in banks...Sometimes you can find banks that are overcapitalized by looking at the Loan Loss Reserve Ratio. This doesn't happen too often, but when you can find one, it is nice. An example of this is BBBI. I suspect that they have too much in their reserves. This is a significant amount for a bank of their size...

      D). There are some truly "off the beaten path" banks that trade maybe 1 or 2 times a month. I wish I had more capital & time. IBBI is an example of this...

      I always look forward to reading your blog, keep up the good work!

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  10. There are a couple of websites which help decipher bank stocks.
    1) bankregdata.com (enter a bank symbol at the top, then look at the 3 graphs at the bottom)
    2) depositaccounts.com/banks/reviews.aspx (use the health tab)

    These two sites can help you judge the health of the bank and give you a sense of it's stability.

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  11. Hi Nate,

    Nice post, could you further explain on using tangible book value as a metric to value banks? Thanks in advance!

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    1. Sure, so I purchase banks when the price to tangible book ratio is below 2/3 and then sell them when that ratio reaches 1x. I do this because a bank's balance sheet is fairly unique, tangible book is loans, cash and PP&E minus all liabilities. Most banks don't own much property or many branches, so tangible book value is a fairly liquid measure.

      Book value is also a common measurement for banks, if you look for articles on bank sales the P/B is often mentioned in the article as a multiple. So where some industrials will sell for EV/EBITDA of 12x a bank might sell at 1.2x BV.

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  12. Crazy...you can't invest in small banks without being an expert on call reports and market area. A basket approach is another option to investing in community banks of this size.

    FDIC.gov has quarterly financial statements and you can download call report data into excel for spreading and VLookup transactions. This bank, Atlantic Community Bank, lost $759,000 in 2012 for instance before tax and shrunk to $80 million to preserve capital.

    I still really like this sector, just have not had the time to do the required research on all the traded banks out there of this size.

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  13. Many community banks trading below book value BUT also earning low single digit ROEs, which seems to justify their discount to book value. Take a look at SBBX, QCRH, CRRB, NECB for example.

    Question: Are you finding community banks earning an attractive ROE (i.e., around 10%) AND trading at a discount to tangible book value? Or are these "oddballs" that you come across rarely when Mr. Market has one of his days?

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    1. Agreed, but I'm buying these on an asset basis, not an earnings basis. Earning power across the board is low right now, interest rates are terrible and unless a bank has an unusual side business (lucrative auto lending, securities etc) earnings aren't going to be all that strong.

      But the assets have real value, especially in an acquisition. There is a lot of talk in banking circles that banks with less than $1b in assets will be unable to pay compliance costs which means there's a large push to consolidate. Most sales are taking place at or above book value, even banks with poor earning power, an acquirer can take advantage of that.

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  14. Why there is that much difference between community banks and multi-national banks regarding balance sheets? What kind of difference it makes..?

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  15. Nate - would enjoy exchanging ideas of banks I'm evaluating. I recently wrote up a piece on QCRH; perhaps you've taken a look at this community banks. Comments welcome! http://undertherockstocks.tumblr.com/post/47625172924/qcr-holdings-qcrh

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  16. Hi Nate,

    While you are talking about banks, do you know any good book on analyzing insurance companies? It seems like dissecting banks and insurance companies' financial statements is the last barrier for me to understand, because so many value investors made a killing in these financials.

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  17. Nate


    Chanced upon it - a couple of learnings I have had from banks :

    1. I would be very very careful about any bank that grows it asset book in excess of 20-25%. It always, always comes back and bite you back later on. If ever " what goes around always comes around" was true, lending. Good credit underwriting is singularly the biggest lever for anyone to make money.The only way to assess this is to do a field check

    2. Look at management compensation in cash and in stock. Check for insiders "buying stocks" (not "options" or "grants") - surest sign that they are thinking long-term. Banking is a circular business - so unlike a unilever, you cannot increase sales without eating off your future.

    3. Check for at least an RoE of 15-17% so as to provide cushion for losses - so even in the worst case, it does not go below 10-12% which should be at least more than cost of capital.

    Thoughts, anyone
    2.

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  18. Epic post, incredibly useful!

    Nate, thank you very much.

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  19. Hi Nate, great post, thanks for sharing this....
    Just wondering that when you calculate tangible book value, would you include items such as "derivative financial instruments' and 'available for sale financial assets' as cash under Assets , thanks!

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  20. Thanks for a great blogg, just stumbeled upon it..
    There are some low valued danish banks right now, they had their pice of the real estate drop allready and things starts to improve. Check out Nordjyske and Lollands bank p/b 0,5. Both went thrue the crisis without losses, need for goverment loans and has over 100% non interest deposists and high equity/assets and decent c/i numbers... there are a few more close to that good aswell.

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