Why We Own CRBC: Investing In Banks

A few notes about investing in banks in general.

Buying shares in a bank at the right price can be almost as good as a license to print money. In more normal times, the average bank in the U.S. produces returns on equity of about 15%, a level of profitability mostly associated with the top sliver of businesses in other industries.

I also like the fact that even small banks have moats – barriers to entry – around their businesses. The average turnover rate for deposits is usually well under 20% at a well-run bank, meaning folks tend to keep an account with a bank for at least five years. The secret? High switching costs. For most customers, it’s simply too much of a pain in the tuckus to switch banks once an account has been set up. Habit and inconvenience can be a good thing for the long-term investor. Add regulatory hurdles and the benefits of scale and owning a bank can become pretty downright attractive.

That said, it is not easy for banks to grow – at least, not at rates that those attractive returns on equity would imply. A level of internal growth tied to the regional economy is almost a given, but above that can be a challenge. That’s not necessarily a bad thing for shareholders, though. Most banks pay out the profits they didn’t use to grow as dividends. Or, at least they did in the days before TARP.

In general, most banks try to grow in one of two ways – by gathering as many deposits as they can, or by making as many loans as possible. To an investor, deposit-driven growth is generally more desirable, if for no other reason than only banks can take deposits. As a result, the profitability of that line of business is higher. If a bank can’t fund operations by aggregating deposits, it has to turn to more costly ways of funding itself. Unfortunately, just about anyone can make a loan, and as we saw a few years ago, just about everyone did. This can result in a double whammy to banks, as margins can suffer due to competition and creditworthiness can suffer due to bad loans.

Just how bad that double whammy can get depends on a few things. Let’s review the business model of a bank to frame them.

If you have a checking account or a car loan, you probably already know the basics: a bank takes in money from one group of people, depositors, lends it to another group, borrowers, and profits from the difference. If a bank borrows money from a depositor at 3 percent and lends it out at 6 percent, the bank has earned a 3 percent spread, or net interest income.

Most banks also make money from fees and other services, typically called noninterest income, which when combined with net interest income comprises the bank’s net revenues.

Much more than other businesses, a bank’s revenue and profits are tied to its balance sheet. You’ll recall a balance sheet is the financial statement that summarizes a company’s assets, liabilities and equity at a specific point in time. The balance sheet shows what is owned, what is owed, and what is left over.

On the asset side of a bank’s balance sheet, you’ll find loans and investments, and on the liabilities side you’ll see deposits and borrowings. One important point to understand about a balance sheet is that while the value of assets may change, liabilities are fixed. Since the amount of assets is always equal to liabilities plus equity, any change in the bank’s assets will be reflected in its equity, too.

If the Bank of Margaritaville had $50 million in both assets and liabilities, but no equity, then a small decline in the value of those assets would mean that the bank could not meet its debts. The bank would become insolvent.

So a bank’s equity is a critical cushion for both depositors and bank shareholders.

What sorts of things would cause that equity cushion to disappear? Bad loans, which effectively reduce the amount of assets on a bank’s balance sheet and therefore its equity, too. A constant barrage of bad loans could eventually drain the equity right out of a bank – if the regulators don’t step in and seize the bank first. And that would be bad for investors. Like, drive-off-a-bridge bad.

Banks are unique, too, in that by investing in them you are by definition going to have to tolerate a higher level of uncertainty when it comes to the financials than in any other industry. The books simply reflect a much higher degree of management discretion when it comes to the timing, categorization and/or classification of a wider range of variables. How can you compensate? A margin of safety, as usual, and by placing an extra level of scrutiny on management.

At this point I should note that among the many intangible factors I like about Citizens Republic and its CEO Cathleen Nash are these:

1 – The CEO leading the bank out of its crisis is not the same one who led the bank into it.

The CEO of any bank that would have failed if not for TARP should be canned. If that person remains at the helm, it’s probably a sign of a passive board, complacent shareholders, and/or an executive who is dug in like a tick. None are good.

2 – The CEO has been buying shares in the bank on the open market.

I believe this speaks of leadership. While it’s not a material amount of buying in Ms. Nash’s case, I can nonetheless count on one hand the number of bank CEOs who have bought their own shares recently.

3 – Finally – let’s just acknowledge the elephant in the room here – the CEO of Citizens Republic is from the South. Or at the very least she’s spent a lot of time down here.

So here’s the deal, yankees:

We’ll trade you C-Nash for LeBron – but the clam chowder stays exactly where it is.

Deal?

Kidding. I am a yankee. A yankee named after a race car driver.

Anyway – almost ready to start drilling down. More in a bit.

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Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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