Monday, January 30, 2012

Investing in Bank Stocks? Buyer Beware!

I have long had a bias against investing in bank stocks (and I suppose insurance stocks as well) because of an inability to ascertain the quality of the assets on the balance sheet.  Unlike a non-financial business that generates cash from operating assets, traditional banks generate money from financial assets, usually loans.  But the quality of the loan and the underlying collateral is effectively impossible for an individual investor (and, I suggest for securities analysts as well) to assess.

The task became even more difficult as large banks moved into trading operations that more resemble hedge funds than a financial entity that earns a profit on the spread between the cost of funds (usually deposits) and the interest rate received on investments (or loans).

I recently have been looking for small banks to invest in, particularly in farming areas that are flourishing.  I came across one (not in the Midwest farm belt) that illustrates the risks of relying on banks’ financial statements.

I long have been skeptical of valuation arguments in support of banks that are based on the stock price selling at a discount to reported book value (i.e., assets minus liabilities).  Many banks—especially the largest—have grown through acquiring other banks.  Quite often, a large bank became large by making dozens of acquisitions over a number of years.  Acquisitions typically require a premium over the target company’s stock price, and the difference between the price paid and the net accounting assets of the acquired bank go on the books as “goodwill.”

For a company like Coca-Cola that has an invaluable brand name, “goodwill” probably has a substantial real value.  But for a bank that has effectively undifferentiated products and services, “goodwill” is a dubious asset.  So a conservative first step in analyzing bank stocks is to remove goodwill from the assets, which produces “tangible book value” (assets minus goodwill minus liabilities).

But even this might not be enough.  If a significant portion of the bank’s assets is made up of loans (or other investments) with shaky collateral, the assets need to be discounted further, reducing tangible book value even more.

The small bank that I was looking at gives a concrete example of such risks.  On the surface, the stock seemed cheap, selling at only 0.5 times tangible book value.  But an alarming deterioration in the loan portfolio backed by commercial real estate makes this apparent cheapness misleading.

To illustrate how heavily leveraged banks are, if this bank’s “troubled” loans are uncollectible to various degrees, this seemingly cheap bank stock will look extraordinarily over valued.  If 40% of the troubled loans default, the price to tangible book value (P/TBV) ratio goes to 1.0.  Not bad.  But if 2/3 of the troubled loans default, the P/TBV ratio goes to 2.6.  And if 80% of the troubled loans default, the P/TBV ratio goes to 13!.  And this assumes no further deterioration in the regional economy and the commercial real estate market.

Bank stocks can be good investments, especially if they are small banks that are acquired at large premia by large banks.  But be careful!

Steve Lehman

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