After the events of the past few years, many investors have concluded that investing in banks is ultimately a speculative exercise. After all, a great deal of management discretion is involved in estimating loan loss reserves and the opportunities for “creative” accounting are far greater in banking than in many other industries. As a result, investors have come to believe that banks are “black boxes” when it comes to asset quality and reserves and are not analyzable. However, in the midst of the wreckage, well regarded investors such as Bruce Berkowitz, Bill Ackman, and John Paulson have been finding value in the sector.
Is it justified to avoid an entire sector even if there is a good chance that values exist? To the extent that the industry is outside the investor’s circle of competence, it is perfectly acceptable to exclude the entire sector and move on to other areas. In order to confidently invest in the largest financial institutions, investors must have the ability to analyze very complex organizations comprised of commercial banking, investment banking, and asset management businesses. However, there are many smaller commercial banks that have relatively simple business models and should be within the circle of competence of most investors.
Community and Regional Banks
The basic business of a community or regional bank is relatively straight forward. A bank is attempting to obtain low cost funds through deposits and other funding sources and then deploys the capital as loans to individuals and businesses at a higher interest rate. The bank’s net interest margin, which is the difference between the bank’s effective yield on assets and the cost of funds, is the primary source of earnings and is supplemented with non-interest income derived from fees and various services provided to customers. This is obviously an over-simplification of the business, but captures the basic idea of what most smaller banks attempt to do.
According to the Federal Deposit Insurance Corporation’s Statistics on Depository Institutions Report, there were 6,676 commercial banks that provided data as of June 30, 2010. Of this number, only 505 banks reported assets of more than $1 billion. The banking market remains very fragmented with thousands of small institutions that have relatively simple business models compared to the money center behemoths.
The opportunities in smaller banks have not escaped the notice of successful investors such as Marty Whitman who was quoted as follows in last weekend’s Barron’s:
Let’s say I can buy a well-capitalized regional or community bank at 80% of book, and it can earn, say, a 10%-15% ROE [return on equity] annually. If it’s sold out to a major [financial institution] in five years at two times book, I’ve probably got a 30% IRR [internal rate of return]. This has worked in the past, and it would work pretty well in the future. And we can make the banks well-capitalized by making capital infusions into them, but we haven’t done any deals yet, though a lot of other people have.
In Mr. Whitman’s case, he may be planning a more activist role in which he makes capital infusions into banks that would otherwise be in trouble, but the basic point is that this is a sector worth exploring. One promising area to look at is an old favorite of value investors: thrift conversions.
One of the more interesting areas that value investors have been involved with for decades is the rather arcane field of thrift conversions. Peter Lynch popularized this concept in Beating The Street and Seth Klarman also discusses the topic in Margin of Safety. In a thrift conversion, an institution that is owned by its depositors sells stock in an IPO. Depositors are initially given priority to purchase shares, but in most cases, shares end up being available for purchase by the public at large. Here is how Peter Lynch describes the process in Beating The Street:
Say your local thrift had $10 million in book value before it went public. Then it sold $10 million worth of stock in the offering – 1 million shares at $10 apiece. When this $10 million from the stock sale returns to the vault, the book value of this company has just doubled. A company with a $20 book value is now selling for $10 a share.
The actual process can be a bit more complex and often involves a multi-step process as described in the October issue of The Manual of Ideas:
In a first-step thrift conversion, an institution that has been technically owned by its depositors may become a stock corporation and raise capital in an IPO. In these offerings, new investors are essentially “buying” their own capital and getting the existing institution’s assets and business for “free.”
Meanwhile, in a second-step thrift conversion, an institution that is partly owned by a mutual holding company (MHC) typically completes a transaction to full public ownership by offering MHC-owned shares to investors.
The Manual of Ideas October issue also includes detailed profiles of two interesting companies that may pursue second-step conversions as well as an interview with Michael Godby, an expert in the field of thrift conversions.
Obviously, the underlying business must be sound for a thrift conversion to be considered for potential investment. A situation where an apparent discount exists could quickly be impaired if loan loss provisions are found to be inadequate or if additional capital raises are required at low prices that dilute existing shareholders.
Many value investors are comfortable with insurance but have not felt comfortable investing in banks. However, there are some similarities in terms of the “black box” issue. Both loan loss provisions and estimates of insurance liabilities are subject to manipulation by managements that are either incompetent or corrupt and it is usually difficult for outside observers to get a handle on these areas. Investors cannot confidently rely on auditors to blow the whistle either.
We have tended to stay away from banking in the past for many of the reasons outlined in this article, and continue to believe that the sector has pitfalls that have the potential to derail opportunities that appear quantitatively cheap. However, while the big money center banks seem very difficult to analyze, small regional banks with simple business models should be within the circle of competence of a much wider group of investors.
Although most value investors are not enamored with the concept of diversification, it may make sense to consider investing in a basket of smaller regional banks or thrift conversions that are quantitatively cheap and appear to have honest and capable managements. Such an approach would not protect against a macroeconomic shock such as another 20 to 25 percent drop in house prices, but it could guard against hidden risks within specific institutions.