When You Buy A Bank…

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When You Buy A Bank… by Fundoo Professor

Proposition 1: When you buy into a bank with your own money, you buy into a highly leveraged situation. That’s because banks employ huge amount of leverage. This leverage will magnify your returns – both positive as well as negative.

Proposition 2: When you buy the shares of a debt-free business with your own money, there is no use of leverage at your or the portfolio company level. But you can do a thought experiment and imagine that you brought into this debt free business with borrowed money and then calculate the expected return on your money.

If you don’t make that adjustment, you are comparing apples with oranges which doesn’t make sense to me. For me, to be able to buy into a bank I love, the expected return on its stock should be materially higher than the expected return of owning a debt-free business that also I love. But, if such an adjustment ensures that I will almost never buy a bank then so be it.

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It’s important to recognize that (1) leverage affects returns no matter where it resides (at the portfolio level or at the portfolio company level); (2) leverage adds to investment risk; and (3) investors should seek significantly higher returns to compensate for additional risk that leverage adds to the portfolio.