Tuesday, June 05, 2007

A Checklist for Investing in Banks:

Albert Einstein said to "make everything as simple as possible, but not simpler." When it comes to analyzing banks, simple as possible is definetely not easy. By all means, banking is a marginal business, but finding out replacement value is tricky. Relying on traditional metrics such as Price to Book and Price to Earnings can get you in a lot of trouble, as I found out the hard way early in my investing career. Using just these ratios would be oversimplifying.

All banks are not equal. There are many ways a bank can add value that are not readily identifiable on a balance sheet.

Source of Funds: Analyzing the source of funds for a bank is probably one of the most important things that you must do. There are a few things you should be looking for. The most important is the cost of funds- the lower, the better. But do not look just at the cost, but the source behind it as well. For example, in 2001, banks could borrow all they wanted at 1% from the Federal Reserve, but flash forward to today and that borrowing would now cost 5.5%. This just shows how some funding sources are more susceptible to interest rate changes. Money market accounts are also very competitive, and savings are usually as well. The golden egg of sources are checking accounts, because they cost no interest and will probably stay that way long into the future. You also want to look at deposit growth. Over a long period of time, has this company been able to grow its "good" deposits(checking, low savings, etc.)?

Assets and Quality: Analyzing assets is a mess. Some companies choose to only invest in government and state municipality bonds, which are essentially risk free but have a low interest rate. Most banks though originate their own loans in order to earn a higher interest. You must not be fooled into complacency however. Some banks may seem like they are squeezing out excess interest returns, but it is only after it is too late that you realize these loans might also be riskier (Think what might happen to most banks' incomes if house prices were to fall 10%). Analyzing non-performing loans and charge-offs over a long period of time is a good way to figure out whether a bank is actually adding value on the origination side of the business.

Non-Interest Income: Finally, there is non-interest income- the more of it, the better. It is usually less dependent on interest rates and the economy, and therefore adds stability to the business. Wells Fargo's non-interest income almost equals its non-interest expenses. But a majority of banks would be lucky to have even 10% of non-interest income to expense. Also, some of this business might have superior growth prospects or other competitive advantages that should be looked into. Read the VIC on Meta Financial for an example.

I am definetely no expert on analyzing banking institutions. But if I was considering investing in one, these checks would be the least I would do.

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