Via Pope Brar
Let’s Remove “The Black Box”
“It’s a black box. Too much risk. I don’t understand banks”. These are the common statements one hears with the mention of a bank as a potential investment. The recent financial crisis has negatively impacted the perception of banks and revealed hidden “spider webs” in the financial statements. The following checklist is based on our analysis of banks, and includes past mistakes of great investors such as Warren Buffett, Bruce Berkowitz, Peter Lynch and more. The checklist focuses on the four pillars of our investment analysis: 1. Sustainability of the business model, 2. Accountability of the management, 3. Value of the investment, 4. Risk factors (i.e. Business/Emotional Risk and Leverage). The factors are discussed in the approximate 35+ item checklist for analyzing a bank.
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SAVR Checklist for Analyzing Financials
Sustainability of the Bank
What is the competitive advantage “niche”? (i.e. Regional advantage, low cost, product offering, economies of scale).
What is the composition of earnings growth over the past five years? (i.e. Organic, buy-backs, M&A)
What is the bank’s cost-to-income ratio vs. peers? Cost/income ratio is the ratio derived from operating expenses and operating income. The ratio measures the proportion of bank’s income that is consumed by operating costs. It is a key performance indicator of a bank’s efficiency. The smaller the ratio, the more efficient is the bank.
Have I performed peer analysis? Have I compared the following?
a. Net interest margin
b. Expense ratio as a percent of revenue
c. Overhead efficiency ratio
* Efficiency ratio – measures non-interest expense/operating costs as percentage of net revenues. (good banks have efficiency ratios under 55%; lower is better).
* Net interest margin – (the spread banks earn between deposits and loans), interest margin as percentage of average earning assets (3-4% average, look for trend), but look at interest rates – falling rates = higher margins, but check type of lending – cars = higher than house.
What is the Return on Equity (ROE) vs. historical data?
How did the bank overcome the previous recession? Did it undertake risky lending and suffer substantial loan loss? Alert, a sign of poor risk taking by management.
What is the 5-Year Growth Rate of Earnings per Share vs. current valuation based on PE/PB? A bank is a business like any, we do not want to over pay for growth. Traditionally, we equate the PE multiple to the long term growth rate of earnings.
If the company is enjoying regional success, can it be extended nationally?
If the bank is focused on sales region, have I checked for recent population and economic growth? The bank’s revenue growth will most likely follow the same pattern.
Accountability of the Management
Have I analyzed for quality of the management? What is the rate of insider ownership? This is the most important area for banks, as management is responsible for risk-taking.
Does the CEO have a good track record (M&A and operational)? Check annual letters and history of profitable lending and earnings growth.
How has the management allocated capital in the past? Have they announced changes to their capital allocation strategy?
Are there frequent write-downs? If not, have I added back one-time charges?
Value of the Investment
What is earnings per share power after provisioning for potential loan loss?
* Loan Loss Provision = Total Amount of Loan – Expected Loan Loss
* Loan Loss Provisions: the loan loss provision is a balance sheet account that represents a bank’s estimate of potential loan losses. For example, let’s say a bank extends a $1m to a retailer for 5 years. If two years later, the retailer runs into financial problems, the bank will create a provision for loan loss. If the bank estimates that the client will only pay back $400k of the total $1m loan or 40%, the bank will record a provision for a loan loss of $600k (Total Amount of Loan – Expected Loan Loss). To be conservative, many times banks will over estimate loan loss provisions. As the recession fades, they are left with a surplus in their estimates. To achieve “realistic” earnings estimates going forward, it pays to estimate the normalized earnings power per share without loan loss provisions.
How much is reserved for provisions vs. actual net charge-offs?
*Net charge-offs: After creating a loan loss provision for a troubled loan, the bank can estimate the amount the borrower can repay. The bank also determines the amount of the loan that will not be repaid. In the example above, if the bank can only collect $200m out of the $1m loan, the net charge off will be $800k.
Has the bank over-reserved for losses? Typically banks over-reserve to be conservative. As the recession fades, surplus reserves add to earnings. Bruce Berkowitz on his Wells Fargo investment in 1992 (Outstanding Investor Digest): “Its earnings power has been disguised by the intense provisioning for loan losses. But when the provisioning gets back to a normal level, you’ll start to see that incredible earnings power come down to the bottom line. And it’s as simple as that.”
Have I checked for the current book value verses historical data and peers? Historically large banks typically sold for more than 1.5x book value. Most of the assets of a bank are in the loans. If you are convinced the bank has avoided high-risk lending, you can begin to have confidence in the book value.
Berkowitz elaborating on his Wells Fargo investment in 1992: “Wells Fargo began to fix its problems in several fundamental ways in the early 1990’s. However, the market did not reflect these changes in revaluing the stock’s price until years after the improvements began.”
Is the bank buying back shares? What is the average price paid in previous buy-backs? (Should be lower than current share price).
How will high unemployment rates and economic recession hurt the business? How have earnings behaved in the past recession?
What is the bank’s exposure to a possible macro-economic shock? (indirect or direct, e.g. US housing)
Is the bank involved in any significant lawsuit(s)?
What are loan loss provisions as a percentage of total loans? The ratio should improve as the recession fades. A consistent increase in an alert for risky lending.
What is the trend for non-performing loans? Has the level stabilized?
What are the loan loss provisions as a percentage of the pretax profits?
What is the bank’s debt rating and preferred debt rating?
What is the growth rate of loans? Rapid growth in loans potentially means the bank is not carefully evaluating its loan portfolio.
Have I tracked deposit levels? Are they growing or declining? A decline could mean the customers are taking their deposits elsewhere.
Is the equity of the bank declining? Watch out – the last layer of protection.
What is the estimated normalized earnings power in “regular” economic times?
Have I checked for the Equity to Assets ratio? The most important number of all; it measures financial strength and “survivability.” The higher the E/A, the better. E/A’s have a wide range, from as low as 1 or 2 (candidates potentially headed for disaster) to as high as 20. An E/A of 5 to 6 is average, below 5 is the danger zone. Prior to investing we prefer to see that its E/A ratio is at least 7.
What is the percentage of Real Estate Owned (REO)? – This is property on which the bank has already foreclosed, watch out for rise in REO, it’s not the bank’s core business.
Commercial loans are more risky than others. What percentage of the loans outstanding are commercial? Ensure it’s below 10% or else potential for a large disappointment.
Is the bank operating in a risky geographic area with corporate governance and/or political issues? (Country exposure: check for credit growth, 90-day non-performing loans; watch real estate prices vs. historically normalized levels).
Are my investments too concentrated on one industry – financials (banks)? (Berkowitz recently had to wait at least 2-3 years for financials to rally).
Am I ignoring things on this checklist because I feel too complacent or attached to my research?