Jul 12, 2020
Mental Models discussed in this podcast:
- Commodity
- Leverage
- Availability Bias (re 2008 Financial
Crisis)
Please review and rate the podcast
If you enjoyed this podcast and found it helpful, please
consider leaving me a rating and review. Your feedback helps me to
improve the podcast and grow the show's audience.
Follow me on Twitter and YouTube
Twitter Handle: @TreyHenninger
YouTube Channel: DIY Investing
Support the Podcast on Patreon
This is a podcast supported by listeners like you. If you’d like
to support this podcast and help me to continue creating great
investing content, please consider becoming a Patron
at DIYInvesting.org/Patron.
You can find out more information by listening to episode 11 of
this podcast.
Show Outline
The full show notes for this episode are available
at https://www.diyinvesting.org/Episode83
Key Characteristics of the banking industry which make it
unattractive for investors
- 2008 Financial Crisis
- I could probably end this episode with that statement alone.
However, there is value in expanding on what bank investors can
learn from the 2008 financial crisis. Specifically, how that event
may be repeated or rhyme in the future and how to avoid owning a
bank that may be affected.
- Risk Management is primary - which is heavily influenced by
management
- A poor management team can quickly ruin a good bank. This is a
problem for investors because it requires evaluating management and
understanding their ability and focus on managing risk.
- This is harder to do than you may expect because nearly all
bank managers are going to pay at least lip service to risk
management.
- Buffett once talked about wanting to own a business that could
be run by an idiot because eventually, an idiot would run it.
Unfortunately, this does not often apply to banks. Why? It will be
more clear as we discuss further issues.
- Banks operate with high leverage
- In many industries, high leverage can be seen as a sign of
risky decision making. With banking, leverage is a feature. High
leverage is not only present across the board in the banking
industry but is required in order to earn an adequate return. I
covered why in episode 79 when we discussed the banking business
model.
- The more leverage a company uses the higher risk of blowing up
or bankruptcy due to deteriorating loan performance. This is why
management plans such a big role. It is easy to grow a bank by
offering loans to people and companies that are not creditworthy.
However, doing so sets up failure down the road.
- Leverage = Double-edged sword. Required for adequate returns,
but the potential source of bankruptcy. 2008 was a prime example of
how this could occur.
- Value Traps abound -> History of low returns, especially
among small banks
- While high returning banks that are able to reinvest capital
into growth offer great opportunities, there are many more banks
that could be a value trap.
- Small community banks often trade below book value which can
appeal to value investors. Yet, you’ll find thousands of banks like
this which may have returns on equity below 10%. Any growth that
these banks experience will lower an investor’s return instead of
improving it.
- Time is not on your side if you select the wrong bank because
they often don’t earn a high enough return.
- Why? Small towns especially have limited capital available to
be stored in a bank. These towns are also heavily hit hard by the
move towards online retail, urbanization, and loss of manufacturing
jobs.
- Bankruptcy risk is higher than a normal industry
- While all companies can fail due to leverage, banks have more
leverage than normal.
- While all companies can fail due to a liquidity trap, a bank’s
entire business model is based on lending long-term and borrowing
short-term.
- Remember, in episode 82, I talked about the benefit of fewer
banks in the industry over time. That only exists because banks
continue to fail and/or be bought out by larger competitors. This
exemplifies that failure IS an option for many banks and requires a
prudent investor.
- Money is a commodity and banks don’t control its price.
- The Federal Reserve in the United States makes a common
practice of manipulating the value and price of money. They
determine what short-term interest rate should be. There may come a
day when that is no longer true, but for now, at least, banks
operate in a manipulated market.
- This means that in general, banks don’t have pricing power. The
most cost-efficient banks will win, prosper, and grow. Everyone
else will fail or shrink away into obscurity.
- The profitability of your common bank will be quite different
in different interest rate environments. The shape of the yield
curve is critical, but any bank you invest in doesn’t control the
yield curve.
Summary:
I want to end this episode with a question. It pertains to both
my last episode on the attractive qualities and this one on the
unattractive. Which of these two sets of information was most new
to you? My guess is that my average listener will be more familiar
with the downsides of the banking industry. The 2008 financial
crisis is fresh in everyone’s minds. We understand what can happen
when banks fail. It is harder to see the massive deals available in
the banking industry when a recent crisis is so prominent.
Either way, I hope this information is useful and challenges you
to think deeply about the industries you invest in. Don’t simply
focus on the attractive qualities. Also, understand what makes an
industry unattractive.
Banking is an industry with many key drawbacks including
dependence on management for risk reduction, high leverage, low
returns on equity, bankruptcy risk, and lack of pricing power
because money is a commodity.
References: