I must confess I have a special place in my heart for small banks. Maybe too many viewings of “It’s a Wonderful Life” and that banking when done correctly is a simple, understandable business with a lot of publicly available data. However, the moment banking gets into trillions of dollars of derivatives, investment banking, 20x leverage, and CDO Squareds, my heart hardens, and I just want to find the exit. There’s a big difference between the 10K of Citi and the 10K of your hometown bank. I can make some sense of the latter.
Considering the fact that small, regional banks have been pummeled for the past few years and are understandable businesses, it’s a great idea to understand how to analyze a bank and figure out what makes a safe bank. After digging through a few books, it took me a year before I finally came across a good way to assess a bank’s credit, and I found it through Morningstar. While not perfect, Morningstar’s Bank Credit Methodology document is a fantastic checklist for assessing the creditworthiness of a bank; helping your really understand how a bank works. Morningstar uses this methodology for the large cap banks they analyze, but with some modifications, it works pretty well when dealing with smaller players, the kind of banks where more opportunities lie.
Simple and Understandable, but not Risk Free
Investing in a bank is not for the faint of heart, but it is one where even a risk averse value investor can find a significant margin of safety with medium business risk as banking done right can be relatively conservative and stable. Good banking holds many of the same principles of good value investing: you have to wait for great quality that’s selling for a good price, stick to your core competencies, and slow and careful wins the race. As long as there is money, we’ll need banks, so product obsolescence is minimal, and you could own a great investment that could last you generations.
However, banks are leveraged institutions, and anything involving leverage means amping up your homework and your willingness to wait for a great bank to sell at a good price. In addition, you’ll have to stay on top of the data once you’ve made your purchase. Normally, I eschew leverage in every industry except in banking and insurance because it’s their job to understand and manage leverage well. As with most levered things, swinging for the fences with banks will get you into trouble, but if you stick to only the very healthy, simpler institutions, it can be a stable source of income and capital gains.
Things You Will Need
Before we get to our future posts where we’ll delve into creating our checklist, a few things are worth noting.
If you’re a beginner and would like a little more information on how a bank actually operates, the Investopedia banking industry article is pretty useful, as is the banking section of Morningstar’s Five Rules for Successful Stock Investing.
We’ll also need a good source of financial data to work from. The FFIEC website is a fantastic resource for all publicly available banking data. All banks are required to submit quarterly call reports and thrift financial reports to them and it’s our primary source for information. It can be a bit of a pain to navigate, but with a little time, you can get what you need.
If you’re willing to shell out a few hundred dollars, you can get a subscription to BankRegData.com which compiles the FFIEC data nicely. BankRegData doesn’t have everything (I’d love it if they added Tangible Common Equity and trailing twelve month data for all their ratios), but they have a lot of nicely pruned data. It will save you many hours if you’re analyzing a slew of banks.
Also, if banking ratios are new to you, I suggest you take a quick look at the following articles. The Baseline Scenario has a great article on tangible common equity for beginners and why tier 1 and tangible common equity are important. Morningstar also has a great overview of many of the ratios as well. Both are worth reading if you don’t understand why, for example, Citi had to convert a great deal of it’s preferred stock into common during the last financial crisis.
In the next post, we’ll talk about adapting Morningstar’s bank solvency test to our needs.
Full Disclosure: I have no position in Citi (C) or Morningstar (MORN)
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