What We're Reading

I'm asked in chat a lot about this bank or that bank and what my analysis is of them.  My answer is always the same.  I can't analyze, on a fundamental basis, any of the big banks.  I've tried, believe me, I've tried.  Hell, I downloaded the annual report of BAC for 2010, grabbed some irish whiskey, a rosetta stone, and locked myself in a room by myself for the weekend.  I emerged at the end of the weekend bruised, hung over, and with empty bottle in hand.  The bruises were from banging my head against the wall.  The hang over? From trying to wrap my head around the riddle inside a conundrum wrapped up in an enigma that is the financials of Bank of America. 

I have no idea how they make any money. In fact, this is why rumors work so well to take the stock down; nobody understands the balance sheet, so they figure the rumor has a possibilty of truth to it.  As much as I respect some of the "value" guys that are in the name, Bruce Berkowitz to name one, I can tell you that they probably don't understand half of what's on that balance sheet( or off for that matter.)  I know that some will bring up that Buffett is in the name as well and that I am questioning the oracle. He owns no common shares.  Actually he's more of a creditor than investor, a capital infusion while charging 6% interest.    Perhaps loanshark would be a better word!

In very simplistic terms, banks make money by taking deposits, paying the depositor a certain interest rate, and then lending that money out at a higher interest rate.  The spread between the two rates is where the money is made.  Why one bank does better than another comes down to the economy and the credit analysis of the lendees.  At least that's how they are supposed to do it.  It seems somewhere along the way the definition changed, at least with the really big banks.  Me thinks it may have happened when our omnipotent government in their emminent wisdom repealed the Glass-Steagall Bank Act 0f 1933.  You know, the act that defined banks as banks and investment banks as houses of ill repute.

Quite simply, the point I'm trying to make is, if you can't understand the balance sheet, stay the hell away from it. If a so-called bank is involved in activities other than traditional deposits and consumer/commercial credit, it better be simple to understand and not incredibly risky, or don't consider buying the stock. That pretty much excludes most of the big, nationwide banks. U. S. Bancorp and Wells Fargo are possible exceptions. I haven't looked closely at their financials, so this is not an endorsement in any way shape or form. In my opinion, stick with regional banks. Size really isn't important as long as the balance sheet is understandable. Of course do your homework on them.

My intention is not to write a how-to manual on investing in banks, but there are a couple things to look for if you are considering investing in one. First, prepare to do some very dry reading. Read the damn annual reports. There is no way around it. I'm not just saying the most recent report, but several years worth. Personally I would go five years back. Look for loan quality in particular. Has the bank made risky loans and paid the price? Or have they had fewer loan losses than the average bank? If you find one with a perfect record, they are lying. Every bank has loan defaults, a good one has fewer than it's peers. A great one has considerably less than it's peers. Secondly, look at the price to book metric. If a bank has a price to book metric that is close to or higher than two, it is either approaching fair value or is overvalued. A price to book metric approaching or below one is a sign that the bank is undervalued. Remember, price to book is only useful when analyzing easy to understand regional and small banks. Price to book on a stock like Citigroup or Bank of America is absolutely useless; too much voodoo and potential for off balance sheet shenanigans.

This all being said. If you absolutely feel the need to buy into the big banks, have me talk you out of it. If you don't listen to my pleading, at least pick one with a considerable reputation for taking lemons and making lemonade. J. P. Morgan and Goldman Sachs come to mind. Both make occasional missteps, but over the long term they have shown resiliency.