A banking primer

Value investors come in two types, the ones who will look at financials, and the ones who won't.  If banking is your forte I would encourage you to read the paragraph on my approach then come back for my next post.  If banking is intimidating or difficult to understand hopefully this post will be educational and break bank investing down into easy to understand pieces.  The bank I use as an example is not a good investment, but I'll cover why.  I think readers will understand how to analyze a bank better by understanding what's bad about banks instead of showing a perfect banking investment.  If anyone thinks I'm long winded something to consider; this post is based off a presentation I gave to my company and I covered this material in under four minutes, I can condense when I need to.

Approach

My approach to bank investing is very similar to my approach to buying any other cheap stock.  I prefer to buy banks at 2/3 of tangible book value and sell when they approach 1x tangible book value.  There are many banks trading at or above tangible book value, and a bank that's profitable should be trading above it, yet many don't.  A lot of stocks trade below TBV due to management mis-deeds, or the inability of a company to earn their cost of capital.  I believe the reason for bank cheapness now is different, we just went through a banking crisis and banks are still considered toxic investments.  Beyond this the market has lost interest in smaller community banks conduct the boring business of gathering assets and re-loaning the money.  Many of these community banks emerged from the crisis unscathed, and in a lot of cases overcapitalized and trading at incredibly low valuations.  Unfortunately market psychology doesn't care much about this, the banks are still considered risky.

Banking basics

Banking is the ultimate commodity business, and at the same time the ultimate niche/moat business as well.  At the most basic level banks are all the same, they take in deposits and loan against those deposits making a spread.  Banks have the ability to work at the edges, but the fundamental business is the exact same for a bank in Peoria Illinois as it is for a bank in Sevilla Spain.

Banks are very simple, they gather money in the form of deposits then they loan that money back to those same people and collect interest on the loans.  Bank financial statements are a bit strange to look at because we think in terms of ourselves most often.  A person's asset might be cash, which deposited at a bank is a liability.  A liability to a person such as an auto loan is an asset to a bank.  The assets and liabilities are flipped from what you are used to seeing on a normal financial statement.  The good news is you only need to learn this once, all banks report in the same manner.

One thing that's interesting about banking is how sticky customers are.  For how commodity the bank industry is many banks have what might be considered a moat.  Bank switching costs are high, it's very difficult to open and close an account, and most customers don't consider it worth the hassle.  I opened an account at a bank a few months back and took my son with me thinking it would be a quick errand.  He's three years old, I could count the time it took to open the account by the number of Dum-Dums he ate while waiting, hint his mother will never know the true tally.  I think from start to finish it was about 45 minutes, that time alone is an impediment for customers to switch accounts, not to mention having to switch billpay and auto-draft numbers.

Introducing Atlantic Bancshares

The bank in this example is Atlantic Bancshares (ATBA), which is a tiny bank located in South Carolina.  The bank has some issues with bad loans which you'll see in a few minutes, but the valuation is attractive.  The bank has equity of $7.2m and is currently trading with a market value of $1.4m, or 19% of book value.  The bank publishes their annual reports on their website, with the most recent update from the summer.  I'm going to use last year's annual report for this example, it's a little outdated, but it doesn't matter much, the principles are universal.

The balance sheet

Assets

Here is the bank's balance sheet as it appears in the annual report:

The structure of any company's balance sheet is important, small differences on the balance sheet can mean the difference between profit and loss.

Starting at the top the first thing you'll notice is cash and cash due from other banks.  Banks hold cash and securities against their regulatory capital requirements.  An item worth noting with this bank is they have a lot of cash but not many marketable securities.  The cash is earning them nothing, where securities might be earning something.  Securities are counted against capital differently than cash, which can drive the composition, all things being equal interest bearing securities are better than cash.

The next important number is "Loans Receivable", in this case the bank has $64m in loans, or 69% of their assets are loans.  In the notes the bank breaks down their loans into the following categories:

Different investors have different opinions on what the best loan makeup is, but there are a few things to keep in mind.  Residential loans have the longest duration meaning a bank is locking in a residential loan rate for a longer term, usually 15 or 30 years.  On the other hand construction and development loans which might have a shorter maturity are much riskier.  Commercial loans carry higher rates than residential loans, but have risks as well.  Residential loans are usually made in smaller sizes, $100k, $300k etc.  Commercial lending is usually in larger amounts, if a commercial loan goes bad one loan could mean a few million dollars in losses, whereas a residential loan might only be a few hundred thousand dollars in losses.

The final lines under assets include bank owned real estate, and any assets related to branches they might own or lease.  The number under owned real estate is important to watch, banks are in the business of lending money, not managing properties.  A large number here might indicate the bank is a poor lender and underwrote a number of bad loans.

Liabilities

I like to scan a bank's liabilities first when initially looking at an investment.  A banks funding base is the first indication of profitability.  The ideal bank setup is one where the funding base is non-interest bearing deposits that can be re-loaned at much higher rates.  Commercial lending falls under this category, most businesses that borrow from banks are required to keep large deposits in order to secure a credit line.  To break this down a company might deposit $500k at a bank and receive no interest on their deposit.  The bank then lends the business $1,000,000 at 8% on a credit line.  In essence the bank is making the business pay 8% on their initial $500k to gain access to the second $500k.  

In Atlantic Bancshares' case only 27% of their funding comes from non-interest bearing deposits.  As one walks down the categories of deposits the deposits become more costly.  An interest-bearing checking account might pay a small amount of interest whereas a CD pays a might higher interest rate.  You'll notice that most of Atlantic's funding comes from interest bearing sources, money market accounts, and CDs.  

The more interest the bank pays out to depositors the less money available for shareholders.  Finding banks with low cost funding structures is important.

The final item to look at on the balance sheet is the capital structure.  Atlantic Bancshares has a 7.37% equity ratio (equity/total assets), this means the bank is undercapitalized and will at some point require a further capital injection.  They did a recent preferred issue in 2011 which is seen under the Series AAA heading.  The bank raised $1.4m in 2011, mostly from directors and existing shareholders.

If anyone is trying to understand why this bank is a bad investment the capital structure coupled with the losses is the answer.  The bank is going to need to undertake costly dilutive preferred or equity offerings in order to meet their regulatory capital requirements.  As the bank continues to lose money the capital ratio will continue to deteriorate, until something changes the outlook is dire.

Income statement

Here is the bank's income statement:

The income statement is where we see the interest mechanics at work.  The bank took in $4.4m in gross interest from loans and interest paid on their marketable securities.  They paid out $1.08m to depositors holding CDs and money market accounts.  The bank then earmarked $1.86m as a provision for loan losses.  This means the bank is expecting to lose $1.86m or more on loans and they're saving this money ahead of time to deal with the problem.

After the bank pays out its depositors, and provisions for losses they are left with their net interest income.  After that is non-interest income, this is where things like overdrafts and one time investment gains are classified.  When you re-order checks and are surprised to learn they cost $24 that fee appears in this category on the bank's financial statement.

The net interest income plus other income is a sort of gross profit for banks.  Out of the remainder the bank pays for operations including salaries, rent, and other costs of doing business.  Following those expenses the bank pays taxes if they made a profit and records their profit or loss.

Some investors like to look at what is considered core banking earning power using pre-tax, pre-provision earnings.  For Atlantic Bancshares in 2011 their PTPP earnings would have been $503,843, meaning the shares are trading at ~3x PTPP.

Compared to the balance sheet a bank's income statement is very straightforward.  Expenses are itemized at a detail level that's unusual for a non-financial company.  What I like about the income statement is it clearly shows the drivers for a bank's profitability.  A few quick calculations can be made, take the interest from loans and divide it by the loans outstanding and you can see the interest rate on the bank's loans.  Take interest expense and divide it by deposits to see what the bank's paying on deposits.

Most of a bank's profitability hinges on two components, their expense management, and their interest margin.  If the net interest margin is too small because they have a high cost funding base they will struggle to maintain profitability.  Likewise if the bank's expenses are out of control there will be no profit left for shareholders.

Concluding thoughts

Astute readers will note I left out two things, a discussion of loan losses, and any discussion of a cash flow statement.  The cash flow statement isn't as useful when analyzing banks as it when analyzing a non-financial.  In a non-financial cash flows can be used to ferret out fraud, for banks other measures need to be used.  Banking fraud does happen, but it requires a bit more ingenuity because banks are so highly regulated.  The biggest risk to a bank investment isn't fraud but stupidity.  If a bank gets lazy and starts writing loose loans they will sink from lax lending standards quicker than anything else.

The second point is much more important, the banks loan losses and trend of losses is vital in determining the safety of an investment.  If the bank has too many non-performing loans they will either fail or be required to raise capital.  The level of NPA's is important, but the trend is just as important.  I didn't touch on this in too much detail because this isn't a comprehensive banking guide, different investors have different NPA preferences, I prefer lower and safer amounts, but some people do well riding momentum as losses start to moderate.

I hope this post has been helpful in explaining bank investing at an entry level.  There are a variety of resources to learn about each aspect of banking at a deeper level, but there is no substitute for practice.  The best way to learn how to value banks is to get out there and start valuing.

Interested in learning more about banks? Buy my book The Bank Investor's Handbook (Kindle and paperback available)

Disclosure: No position in Atlantic Bancshares