Bank Valuation VII

I apologize for the slightly longer than usual time between posts these last two weeks.  Its been a busy 2 weeks.  Up to this point in this series, I have discussed only quantitative/numeric metrics.  However, in this article I will discuss some qualitative metrics related to bank itself. The final article in the series will be posted the following week.  So far we covered the following metrics:
– Net Interest Margin (NIM)
– Return On Assets (ROA)
– Loan Loss Reserve,
and losses related to the loan portfolio
– Return On Equity (ROE)
– Profit Margin
– Dividends
– Earnings
– Stock Price
& Price/Earnings
– Net Asset Value (NAV), Book Value, Price/BookValue

To review them see Bank Valuation I, II, III, IV, V, VI

What I present here are techniques that I have found useful in evaluating opportunities in bank stocks in particular.  They will help you to become aware of certain risks & situations affecting banks that you will have to weigh, while helping to avoid problematic ones.  There are many other techniques and methods out there as well.


Warren Buffet has a good saying: “Its better to buy a good company at a fair price, than a bad one at a discount”.  Why is this important?  Because a bad company is more likely to make you lose money than a good one.

How can we tell which companies are good and which are not? Buffet also has some advice on this aspect as well. “Investing is most profitable when it is most businesslike”. From my own experiences related to business & investing, I have found this to be very true & well put.

For stocks, the idea that you actually own a piece of a business may seem very distant, but nonetheless it is true.  As an part owner or silent partner (although sometimes you may be called upon to vote on issues), it makes sense to look at the company with a business perspective.  It should be no different than the mentality you would have if you were to be a silent partner and shareholder of a private business.  Would you just partner up with some owners and pour money into a private corporation without looking at some numbers (as covered earlier in the series) or qualitative characteristics (this article)?  Of course not!  The same rule should apply here to publicly traded ones.

After crunching numbers (quantitative metrics), there are two key areas to look at for the qualitative metrics.  One is the concerning the business itself, and the second is the management that runs it (your partners).


When looking at the company you should ask yourself if it is one that you would want to own, if it were a private business? Why or why not?

Before we begin to think about and answer that question, we must answer another question first. Do you understand how it company operates & generates profit? Knowing how traditional retail banks generate revenues differently compared with commercial, or investment banks, helps to understand the associated risks that may affect the business.  Having knowledge of how the company’s revenue streams work are essential.  How much is coming from retail consumer deposits & account services, loans, investment services, compared to business accounts, services, loans, etc., or capital market activities?  Even among each category, what type of loans are being made, and do they make up the majority of loans?  What is involved in the investment services?  What type of investments does the bank or firm actually make? Knowing this helps to make the business qualities clearer before investing.  Its surprising how many people bought into Wachovia, for example, but didn’t have a clue they were heavily into CMBS, CDOs, and other exotic debt related activities.


So what is it, that would make you want to own shares of a specific company (assuming you understand its operations), that can’t be easily described with numbers? Some reasons may be that it maintains a dominant position in its industry, has strong brand loyalty, unmatched quality.  Or, what makes you NOT want to own a portion of a particular business?  Some reasons might be that there are too many strong competitors & rivals, or a weak product pipeline, etc.  These questions will help to point out strengths & weaknesses of a company that may not be obvious from their numbers alone.  These same questions can be used on banks as well:

– What are the prospects for the business?  Sustainable?  You want a company that will be operating over the long run, and not in it for quick profits which would leave investors out to dry.
– What is their positioning?  Are they setting themselves up for future growth, or just focusing on the current marketplace environment?
– Who are the customers? What is the customer make up?  Is the customer base large enough to sustain their business and generate enough revenues over the long run?  Who aren’t their customers, and can they be potential ones in the future?
– What are the products & services being offered?  Is it something that is wanted or needed?  Is it in demand?  Will it still be in demand in a few years, or just a fad that will fade?  Will customers purchase again, or require continual services?
– How does their product/service pipeline look?  Anything to replace current & aging products/services?  You want to make sure they have continuous product/service offerings or adjustments in order to maintain and grow the business.
– How strong are the main business lines?  Any trouble or weaknesses in them?
– Is there any brand recognition or loyalty?  Or will customers easily switch to alternatives?  Do they command Coke & Pepsi-like brand loyalty where customers do want to switch to other brands and keep coming back for more?
– What is the company’s image?  Any negative publicity which may affect sales?  Do they do anything to ensure good public relations?  What does the general population or customer base think of the company?  Do they want to continue purchasing products/services from them?  Are they staying away?  Any green initiatives, charity work, or community service?
– What are the main strengths of the company?  What are they known for?  What are they good at?
– Do they have some kind of sustainable competitive advantage or moat?  Is there anything that gives them an advantage or make the stand out?  Monopoly power, low cost processes, standards, or processes/systems that cannot be easily duplicated and shelter them from competition? Economies of scale (better buying & pricing power, lower costs due to large size/volume)?  Strong network effect (more people who use, the more useful their product/service becomes)?  High switching costs for customer?
– How do they compare to their peers?  Are they struggling to win customers, get regulatory approvals, waiting for bailouts? Or are they dominant in their industry, or striving to be industry leader?  Are their sales & revenue growth slower than their peers?  Or are they growing faster, indicating an expanding business?
– What are likely uncontrollable external events that will negatively impact the company?  How exactly would they affect the business?


When looking at management that runs the business, you should ask yourself if you can trust the management team to operate the business with shareholder best interests in mind?  These questions will help to point out dangerous red flags, or best-of-class management qualities that may not be obvious from their numbers alone:

– How do they handle uncontrollable external events that negatively impact the company?  Do they even have a plan in place to mitigate them?  If they occurred, how was it handled?
– How honest have they been in the past about their own mistakes or failures?  Do they candy coat it or tell it as it is?
– How do they deal with their own mistakes?  Do they fix them or let them slide?
– Honest with customers – You don’t’ want to be involved with dishonest companies who try to scam or gouge customers.  Companies that use false advertising, or sell unsafe products take the short term approach and eventually lose customers (revenue stream).
– How honest has management been about the company’s outlook in both good and bad times? You also want management to be honest and speak openly about any issues they are facing.
– In quarterly and annual reports, do they make it difficult to find specific information or numbers?  Do they try to make numbers look better or worse?
– How do they compare against industry peers?
– Do they resist the institutional imperative (herd mentality)?  They make decisions based on their own information, knowledge, and strategies, not based on what everyone else thinks is right.  We don’t want lemming style executives taking the company over the cliff with everyone else.
– Do they use common sense & logic?
– What is experience do each top member bring to the company?
– Do they panic when in the face of challenges & difficulties
– Do they seem to be in it for the long term?  We want management to build & grow the company for years.
– Values – bad values and leadership can be costly in the long run.  Short term approach to make fast money eventually leads the company down an unprofitable path.  Some classic examples are companies that try to reduce expenses by cutting corners.  They may start using inferior or even unsafe materials in their products.  Causing massive recalls and safety advisories.  This definitely hurts the company’s image, sales numbers, and profits. Not to mention causing lawsuits.  Stock prices of such companies usually take a massive beating once news comes out, and the company usually has difficulty recovering.
– Are they passionate about the company and its business (interest to see the company do well, not just for monetary reasons)?
– How conservative are their decisions?
– What are the corporate goals, vision?  This will be the direction for the company.



Business Examples:

– Wells Fargo & Company (WFC) provides retail, commercial & corporate banking services through banking stores located in 23 states.  The bank also provides other financial services through its subsidiary companies, including wholesale banking, mortgage banking, consumer finance, equipment leasing, agricultural finance, commercial finance, securities brokerage, investment banking, insurance brokerage services, trust services, investment advisory services, venture capital, etc.  Its consumer finance operations make direct consumer and real estate loans to individuals and purchase sales finance contracts from retail merchants from offices throughout the United States, and in Canada and the Pacific Rim.
– In Wachovia’s (WB)  2006 Annual report, they stated they are the number one market leader real estate and structured products (master servicer of US CMBS, CMBS fixed rate loans, manager of US CDOs, etc).  Commercial mortgage backed securities, Collateralized debt obligations were all sources of the present credit crisis.
– TD Bank Financial Group (TD) serves more than 14 million customers around the globe through its business segments.  Canadian Personal and Commercial Banking business are served through TD Canada Trust (Wealth Management, including TD Waterhouse and an investment in TD Ameritrade), its Wholesale Banking served through TD Securities.  Its United States Personal and Commercial Banking served through TD Banknorth.
– US Bancorp’s (USB) banking and investment services are provided through a network of 2,518 banking offices operating in 24 states in the Midwest and West. The bank operates a network of 4,867 branded ATMs.  USB expanded by opening new branches in 2007 and 2008, while others were cutting staff, selling off assets, and experiencing severe capital and debt related problems.  They also recently acquired the banking operations of two separate California financial institutions from the Federal Deposit Insurance Corporation (FDIC).  The institutions acquired are Downey Savings & Loan Association, F.A. (the primary subsidiary of Downey Financial Corp. [DSL]), and PFF Bank & Trust (a subsidiary of PFF Bancorp Inc. [PFFB]).
– CIBC’s (CM) recurring security breaches of customer accounts and information.
[Update Nov 27 2008: CIBC unable to verify whether client data was actually lost. GlobeAndMail]
– The Bank Of America (BAC), TD Bank (TD), HSBC (HBC), and Umpqua (UMPQ) brand names.
– Umpqua’s innovative retail flavored “store” atmosphere & design (branches), exceptional customer service, culture, help to differentiate itself from all other banks.
– Canadian banks benefiting from low local competition from other local banks (Royal Bank, TD, Scotiabank, Bank Of Montreal, CIBC, Desjardins [Quebec]), international banks (HSBC), direct banking institutions (PC Financial) and few credit unions (Duca).


Management Examples:
– Management at Wells Fargo and US Bancorp did not follow the industry crowd.  They didn’t dip heavily into the subprime mortgages and exotic debt/asset-backed investments in order to boost their returns & quarterly numbers, even though almost every other bank & investment firm did.  These banks are stellar examples of using their distribution network, brand, and quality to earn higher than average ROE without unnecessary risk, as well as resisting the institutional imperative in all aspects.  As a result the majority of investor’s didn’t flock to these stocks because their numbers were not as rosy, but it suited the management just fine.  They had rather have numbers be lower (but still impressive), knowing it the growth was sustainable and less risky.  Subsequently, this left these two banks with huge amounts of capital during the current crisis, allow them to make several strategic acquisitions, while their peers could not.
– Management from countless investment banks and financial institutions including Bear Stearns, Lehman Bros, Washington Mutual, Citigroup, CIBC, Wachovia, etc were lured into risky debt based investments, which boosted returns in the short term, but lead to massive losses and some failures.
– Umpqua’s strategy of growing their business one branch at a time, and focusing on serving customer needs, rather than with risky but potentially higher return investments.
– Ray Davis (Umpqua CEO) created a banking environment that was distinctive, attractive, and inviting, compared to the traditional banks (roped lines , empty desks, stale coffee, uninteresting brochures, limited waiting areas). He offered free internet access, Umpqua-branded coffee, spacious waiting area, and LCD televisions.  He wanted to make people feel like they could “hang out” at his bank stores, and read a tastefully printed brochures about the products & services offered.  He also places significant emphasis on their distinctive corporate culture and corporate programs, which has produced successful results in all areas.  Some of these programs include a culture-infused training program, hiring people with retail experience, communicating “knock your socks off” customer service, every team to begin the day with “motivational moments”, accessibility of its corporate executives, annual “Celebration of Excellence” awards given only to front line workers (no awards given to management), President’s Club that recruits cultural ambassadors from within the company, return on quality program, etc. He also shares his wisdom and successful strategies through his book (Leading for Growth: How Umpqua Bank Got Cool and Created a Culture of Greatness).
– Warren Buffet & Charlie Munger, invest on behalf of Berkshire Hathaway.  They have all the characteristics of top notch management, in every way (compensation, shareholder’s best interests, resisting institutional imperative, honesty, integrity, conservative, knowledgeable, ignores hype, does not panic, logical, etc).  This has led to Berkshire Hathaway being one of the most (if not the most) capital rich corporation in the world, giving it an advantage to invest with significantly more favorable terms over all others.  Investments made now by Berkshire Hathaway and its subsidiaries will definitely produce huge returns, as well as setting itself up to reap more advantages in its future.


Next week in the Bank Valuation VIII, I will wrap up the series with a discussion of calculating the intrinsic value of a bank.

Thanks & Happy Investing!
The Investment Blogger

Data sources for this article are from S&P, Morningstar, Reuters, Bloomberg, corresponding bank websites & financial reports.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s