I’ve received a number of follow-up questions to my Silicon Valley Post and the most common question is “How do I Invest in Financials?” I’ve always owned some bank stock. It’s a business that I understand from working in the industry for sixteen years and attending the ABA’s Graduate School of Banking. I’ve also made a number of mistakes investing in the industry and can share some lessons from that experience.
How Does a Bank Operate? The Overview
Banks are mostly a boring business. They take in deposits, pay a low rate on those deposits, then loan the money out to consumers and small businesses at a rate (hopefully) higher than the deposit’s costs. The difference between the rate they pay on deposits and the rate they pay on loans is called the Net Interest Margin. You’ll see this number generally range from 2.5% to 4%.
The banks must pay the depositors back when they ask for money, but 100% of the loans will not be paid back. The bank sets aside some money for losses on these loans, known as a provision for credit losses. In a bank’s earnings report, you’ll see some discussion around provisions: Did provisions go up or go down? Why?
Banks generally have some non-interest income, such as service charges on accounts, overdraft fees, mortgage lending (since these are originated and sold), and various ancillary services they provide. This income is known as non-interest income in the financial statements.
Non-Interest Expense: These are all the costs of running the bank outside of paying interest to depositors. These costs are employees, infrastructure, and ancillary services.
Bank assets primarily consist of cash, loans, and marketable securities which are primarily low risk bonds. Other assets might include real estate for their bank branches and goodwill, the price paid above net assets in an acquisition.
Bank liabilities primarily consist of deposits. If an individual has a deposit account at a bank, then the bank owes them money. Other liabilities might be debt issued by the bank (bonds) or borrowings from the federal reserve or federal home loan bank.
Equity is the difference between bank assets and bank liabilities. Typically a bank will operate with 8-12% equity. In other words, if a bank has 10% equity, they have $1 in shareholder equity for every $9 in liabilities. Since loaning out deposits is a low margin business (2.5% to 4%), the bank requires this structure, which us finance folks call “leverage”.
What can a bank earn?
Well run banks can earn a 12-15% return on equity over a long period of time. These banks accomplish this by making good loans, having a deposit franchise with below average costs, generating decent non-interest income, and being disciplined on expenses. When credit losses are minimal and non-interest income spikes, banks can earn more than 15% and when there are struggles with loan repayment, even a well run bank will fall below a 12% return.
Investing in Banks
If banks can earn a 12% to 15% return, why are they tough investments? The upside is mostly capped at the 12-15% returns, yet there are a number of things that can happen with the business that can crush shareholders. This makes it an investment with an economically capped upside with all these low probability / high pain risks that can wipe out an investor.
What are the Risks?
Balance Sheet Risks
The two biggest risks for a bank are credit risk and asset / liability risk.
The traditional banks suffered significant losses due to credit risk from 2007-2011. Banks can withstand 1-2% loan losses and many were seeing levels higher than that. Banks concentrated in residential housing lending or lending to all the businesses that support residential housing were especially hard hit. Many of these banks failed or were forced to raise capital at a time it was really expensive. Some of these banks did nothing wrong, a community bank making real estate loans in suburban Atlanta never modeled all of its collateral going down in value by 40% or more. There were large counties around the city without a single surviving community bank. SunTrust Bank was the #1 home equity lender in the state of Florida and only survived thanks to ownership in Coca Cola stock.
The Oil Bust of the 1980s was another example of credit risk taking down banks. Entire industries that banks loaned to went to zero. There’s a ratio related to problem loans known as the Texas Ratio thanks to this experience.
Asset / Liability Risk:
Banks intend on loaning money at higher rates than deposits. However, when rates move rapidly, banks can get into trouble with a mismatch of loans and deposits. In the early 1980s, Savings and Loans had too many fixed rate CDs while rates on loans rapidly fell and mortgages were refinanced. Today, the Federal Reserve raised short term interest rates from 0% to 4.5% in less than a year, while there are trillions of dollars in assets in the world yielding +/- 3%. The banks that are heavy into these fixed rate assets and/or have deposit costs that move quickly up have asset / liability risk.
The most pronounced of these issues have been with banks that saw massive deposit inflows in 2020-2021 and the only available places to put the money were low yielding bonds. Silicon Valley Bank had its deposits triple thanks to technology / venture capital deposits while Silvergate and Signature Bank of New York relied on an influx of crypto deposits. As of late March, First Republic of San Francisco is in the news. This bank doubled its deposit base in three years and is well known as a preferred (low rate) lender on commercial real estate and high end mortgages. FRC is generally known as a customer friendly bank and well liked, but is challenged if its average loan yield is under 4% while deposit costs rapidly rise.
The Federal Government provides numerous support services (FDIC, Federal Reserve, Federal Home Loan Bank, Office of the Comptroller of the Currency) and for those services banks are monitored and enforced. Regulation is the rules set by congress and the agencies and enforcement is the intensity at which those rules are enforced. The other challenge in banking is rules can be changed on the fly in times of distress and distort market forces in exchange for stability of the industry.
For example, the FDIC insurance went from $100,000 to unlimited for transaction accounts in 2008 for a temporary period. The higher risk banks could suddenly provide the same risk for depositors as lower risk banks. People responsible for managing their company’s money no longer careed about bank risk because of the implied backstop of corporate accounts. Products such as Insured Cash Sweeps and Treasury Sweeps to mitigate this risk became obsolete. Fourteen years later, many (presumably) smart depositors of Silicon Valley Bank who never managed deposit risk before suddenly ran their own bank and demanded to be made whole for a risk they no longer managed.
There is also the financial risk of retroactive fines. The most egregious example of this are fines. Substantially every affordable housing lender using FHA loans in 2005-2008 was fined in the mid 2010s for activity that was deemed perfectly acceptable when the loan was made, but unacceptable later.
With regards to SVB, members of congress are using this failure as a call for more regulation, when I think the opinion in both the industry and regulatory agencies is that this is an enforcement issue. The challenges were known, but everyone expected it to be corrected with time before a bank run by VCs changed that calculus. In hindsight, regulators likely wish they would have forced the bank to raise more equity when this was known by November of 2022.
The US has chosen a banking system that relies on a minimal amount of equity $1 for every $8 to $12 in liabilities with micromanagement from federal and state regulators. Attempts to change this and reduce regulation in exchange for more capital have been brought up and failed (See the Financial Choice Act). Personally I’d rather see a higher threshold of capital across the industry, size limitations, and less regulation. I think that has less risk to the United States than a behemoth bank like CitiBank that’s thinly capitalized, micromanaged by the government, and has failed at least twice in my lifetime.
Management / Board Risk:
It is challenging for shareholders to hold leadership of a bank accountable. Typically bank boards are comfortable part-time jobs paying anywhere from $30,000/year for a small bank to $400,000/year for a large institution. These boards can range from mostly independent to a board chaired by the CEO with board members mostly handpicked by that CEO. The board members often have a token amount of stock with a goal of extending their comfortable part-time job.
To further protections, the banking industry lobbied to force any shareholder owning greater than 10% to register as a Bank Holding Company, which makes activist investing more challenging. Unfortunately many bank boards and management teams today look just like Teldar Paper…
Due to the Bank Holding Company rules, one activist can’t generate the type of change in an undervalued company like they can in other sectors. This can cause a company to remain undervalued for years.
So now that I’ve completely scared the audience on the topic, we’re now to Part 2
How To Invest in Banks
Rule #1: The price you pay matters.
Stocks have many valuation methods: Price to Earnings Ratio, Price to Earnings Growth, and Price to Book. In my opinion, the most important valuation metric in a bank is Price to Tangible Book Value per share. Tangible book value is the accounting calculation of assets minus goodwill minus liabilities. Then that number is divided by the number of shares outstanding. In theory, this is the liquidation value of a bank if it recovered all of its loans, less its loan loss reserve, and paid back all its debts.
If the upside is capped at a 12-15% return on book equity, paying more than book value mathematically reduces the expected outcome.
Can you buy banks at book value? Yes. Typically banks trade around book value in times of panic or when they’ve been mismanaged. Smaller banks are also more likely to trade at book value because they have fewer shareholders and more retail (individuals) owning the stock.
Typically Price to Tangible Book is reflected in a ratio, with 1.0x representing a stock price equivalent to the company’s book value per share. This means the main buying opportunities for banks are either during times of panic or during a pending management change.
Rule 2: Making loans is easy, collecting loans is hard.
Beware of rapid growth, especially if that growth did not come from a merger. It is *very easy* to just “make more loans” by reducing credit standards or reducing prices. First Republic Bank is beloved by their customers because they are *easy* to do business with. They are also known to be a low cost provider to a wealthy client base. Even if it turns out they weren’t taking excessive credit risk, they grew 2x over a three year span by being the low cost provider.
Rule 3: Be willing to sell when multiples expand.
Banks should earn money each quarter, pay part of that out in a dividend, then use the rest to grow their tangible book value per share either through retained earnings or share repurchases. This should grow the tangible book value per share over time.
The other factor that affects the share price of a bank is its multiple over book value. If you’re interested in investing in bank stocks, be willing to sell when their values start pushing 2x book value. If you pay twice book value for a company with underlying earnings of 12-15%, you just purchased a 6-7.5% earnings stream. The risk / reward of that calculation does not make sense vs investing in an index fund.
Investing in banks is investing in a generally consistent business with a few tail risks. Put another way, bank investing is incredibly boring outside of a few moments of terror.
Some History of Bank Investing: Some failures, successes, and TBDs.
Lesson #1: Multiples matter.
I was on vacation in 2013 and dug into Bank of Hawaii. It has / had all the hallmarks of a great bank: solid deposit base, good market share, and operating in an area with limited competition. The bank was conservatively run, maintained significant capital, and didn’t need to raise additional equity. Unfortunately the bank’s stock traded much higher than its book value.
Here’s a quick chart of Bank of Hawaii, including its book value and Price to Book. My purchases in early 2013 turned out to be a decent choice, the company had a book value of $22.83/share and it could be bought in the low $30/share range.
By the end of 2017, the stock traded for $72/share even though book value only rose to $29.05/share. The underlying growth plus multiple expansion made it a nice win.
You can also see the steady growth in book value that occurred until the end of 2021, when interest rates started hurting its bond portfolio. Fortunately I had sold most of my holdings, but it is now back priced close to 1.5x book value.
Lesson #2: Loans to Deposit Ratio, “Adjusted” EBITDA, and Management.
I recently had this exchange on Twitter, where a financial independence / dividend writer I respect recommended buying this trash fire of a bank:
TFC, formerly BBT, was a darling of Wall Street for nearly two decades. A relatively unknown North Carolina bank followed behind Wachovia and Bank of America expanding throughout the southeast in the 1990s and 2000s. The company briefly “struggled” in the mid 2000s because it refused to take the mortgage based credit risk of its peers, then made it through the Great Financial Crisis without losing money in any quarter or having to issue new equity.
Unfortunately over the following decade, the company’s management got addicted to the cycle of meeting earnings expectations through reducing lending staff and meeting top line growth through mergers. The board started paying out “merger success bonuses” with each deal and essentially incentivized the leadership to keep making purchases, regardless of price or fit. Earnings per share started using the term “adjusted” instead of GAAP and “merger related charges” became a common theme in every press release. The company had the classic board / management setup outlined in the Teldar Paper example, with a CEO who was with the company for 40+ years picking the board members.
Eventually the constant reduction in lending staff caused a portion of its loan book to be replaced with securities. These assets yield less and don’t come with the ability to sell other services to a borrower. The loan to deposit ratio, which shows how well a bank does loaning out its deposits fell from nearly 100% to 70% over this period.
The concentration in securities vs. loans caused the bank’s stock price to fall dramatically in 2023 when the market realized the numerous issues with banks taking a large portion of its deposits to run a bond fund. As of 3/31, the stock closed at $34.51, which is below its 1998 peak of $40.31/share. That’s over twenty five years of negative price growth with a small dividend paid.
What are my current holdings?
Bank of America:
I believe Bank of America is the best run of the four large banks. The core of Bank of America’s business is simple: Be the #1 provider of checking accounts to individuals and loan that money out in low risk loans to larger companies. This provides them what should be the lowest cost deposit base in the country and a relatively low risk loan portfolio.
Bank of America does many other things, but that remains the core of its business.
As of 12/31/2022 Bank of America’s tangible book value per shares was $21.83 and its share price at 3/31/2023 was $28.58, pricing it at a 1.31x Price to Tangible Book Value ratio
First Republic Bank (Preferred Stock)
First Republic is in the “eye of the storm”. The company has major issues related to its loan pricing and securities portfolio. I think their common stock is nearly worthless, but do believe the franchise itself has a positive value to an acquirer. I believe that every week that goes by, the higher the chances of survival.
The preferred stock has a par value of $25/share and similar issuances from other banks are worth $18-$22 per share depending on interest rates. Today FRC’s preferred issuances trade between $5-$8. I think this is a binary outcome investment. If FRC survives, these are worth $18-$22 per share and if FRC fails, the investment is worth zero. We’ll see how this plays out.
As a side note, Bank preferred stock is a great fixed income style investment for a taxable account. It pays a market rate and the dividends are taxed at the dividend tax rate vs the interest income.
The Appalachian Banks
I like the risk / reward posed by some banks that have old deposit franchises in slow growth economic areas then loan those deposits out in better markets. I’m also more familiar with the area’s geography and opportunities than other markets.
Skyline National Bank (Parkway Financial). $PKKW. This is a well run bank headquartered on the VA / NC border. They operate rural bank branches then loan that money out in larger nearby cities and large state college towns. Generally markets anchored by a 1st tier state college do well regardless of the economy. Students will still occupy apartments and visit local watering holes, which in turn pay rent to a landlord who can then pay the bank. The bank sells for less than it’s Tangible Book Value.
Summit Financial: $SMMF. This is a West Virginia based bank with a lending presence in DC. It’s a straightforward bank that managed to grow tangible book value while most smaller banks took losses in their securities book last year. The company’s tangible book value per share is $22 and the panic of March 2023 gave me an opportunity to buy right around Tangible Book Value.
Ameriserv Financial $ASRV. This is a small bet on a Teldar Paper scenario. An activist investor, Driver Capital Management, is taking on a 20yr low performing bank. This institution operates in Western Pennsylvania and should perform better. The business model should be simple, take in low cost deposits in their branches and loan those deposits out in better markets such as Pittsburgh PA and State College.
Unfortunately execution has not occurred for years and the company currently trades for just over $3/share vs a tangible book value of $6.02 per share. There are numerous issues here, including that in 2021, the board set corporate goals well below peer median then still delivered bonuses even though the company missed the already low performance targets. The earnings releases are riddled with the terms “adjusted” and “one time charge” instead of just referencing GAAP earnings.
The activist investor has nominated three directors for vote and instead of allowing the shareholders to vote for an alternate option, the Bank has filed a lawsuit to invalidate the election and has yet to schedule an annual shareholder meeting for shareholders to voice their opinions. These actions have sunk the stock price further.
I view this investment similar to the FRC preferred, it is a binary bet on management change or status quote. I’ll either see an improvement of performance or I own a stock that will go nowhere. It would be fun if I had five million dollars and could just buy 9.5% of the company and influence some change.
What other bank investing comments do I have?
I personally think out of the large banks, Bank of America and M&T Bank are the two most insulated from the current issues. Bank of America for the reasons above and M&T managed their securities portfolio appropriately and didn’t take the asset / liability mismatch losses of other banks.
Outside of those two, research smaller banks in areas you are familiar with. Information is available in both their press releases and public call reports. Look for straightforward earnings and management that doesn’t make excuses for performance with terms like “adjusted earnings” and “one time charges”. See what reputations they have in the community. Pull an FDIC call report and lookup important data about the bank. How much do they have in deposits? Are they loaning out all their deposits or relying on a large securities book? Look for the line that says Other Comprehensive Income (OCI) and it will tell you about any losses in the bond portfolio. Look in their earnings release for comments about Net Interest Margin and what the bank’s comments are on the yield of the loan book vs. the cost of deposits.
Finally, look to see where the tangible book value is. How much does the stock cost relative to tangible book value per share? If it’s a well run bank and not close to tangible book value, just write down a reminder to look the next time a “bank crisis” makes headline news. That might give you an opportunity.
Disclaimer: Outside of my Bank of America stock, the other positions are “hobby size” and nothing in here should be taken as an investment recommendation. Index funds remain the largest portion of our invested assets. This is only meant to provide information about how to analyze a bank if you ever want to own it for similar hobby reasons.