Thursday, July 18, 2013

13% and 15% Pretax Returns Now!

Banks/financials have been announcing earnings and they have been looking pretty good even though there is debate about the quality of some of the earnings (reserve releases etc.).  There is a lot to talk about but I just thought I'd make a quick update on Wells Fargo (WFC) and J.P. Morgan (JPM) as I have talked about them a lot here.

Buffett's 10x Pretax Earnings / 10% Pretax Yield Idea
I am just going to look at the simple Buffett metric; pretax return on investment.  I've mentioned this metric on another WFC post not too long ago.  Buffett has said in a recent annual meeting that he would like to pay 10x pretax earnings, Alice Schroeder (Buffett biographer) has said that that's all Buffett wants to do; make a 10% pretax return on his investment with little risk.  Munger also used WFC as a benchmark investment against which other potential investments would be compared a while ago; is the potential investment more attractive than WFC?  I think he said at the time that WFC is priced at a 10% pretax yield so if something doesn't measure up to that, why bother?

WFC Pretax Earnings
For the past four quarters, here is the pretax earnings trend for WFC:
                    Pretax           Preferred                Pretax
                    earnings         dividends               earnings (less preferred dvd)
2Q2013       8,471             247                       8,224
1Q2013       7,640             240                       7,400
4Q2012       7,221             233                       6,988
3Q2012       7,510             220                       7,290
                  30,842             940                     29,902

So on a trailing twelve month basis, WFC has earned $29.9 billion pretax (and after preferred dividends; I ignored minority interest as it is small).

WFC is now trading at around $44.00, so with 5.3 billion shares outstanding, that's a $233 billion market cap; WFC is trading now at a 12.8% pretax yield on a trailing twelve month basis.  12.8% pretax yield in a world of 2.5% interest rates is pretty attractive (of course, I would never price a stock to a 2.5% pretax yield, though!).

I don't think there is any doubt that Buffett still finds WFC attractive at these levels (he has been buying more all year).  Using his 10% pretax yield, or 10x pretax earnings valuation, he would probably be buying WFC (as long as he is allowed to) up to $56.   That's almost 30% higher than here.  And keep in mind, if I understand everything I've read about Buffett, $56/share for WFC is a price that he would be interested in buying the stock, not some notion of intrinsic value, fair value or anything like that.  It's a price that he would be willing to pay.

There are some issue with banks that people worry about, but we'll look at some of that later.

JPM Pretax Earnings
So let's take a look at another favorite on this blog.   JPM also announced pretty good earnings even though some argue that reserve releases make the number not so high quality.

First, let's just look at the numbers:

               Net to
               common                 Income      
               shareholders           tax             "Pretax income"
2Q13      6,101                     2,802          8,903
1Q13      6,131                     2,553          8,684
4Q12      5,322                     1,258          6,580
3Q12      5,346                     2,278          7,624
             22,900                     8,891        31,791

For pretax earnings here, I just took the net income to common shareholders and added back income taxes paid.  JPM is now trading at around $56, so with 3.8 billion shares outstanding that's a market cap of $213 billion.   That's a 14.9% pretax return, not bad at all.  We can see why Buffett likes JPM (assuming he still owns it.  I don't think anything has happened recently to suggest he doesn't own it; the whale loss didn't seem to bother him at all).

Using the above measure, Buffett would pay up to $84/share for JPM (10x pretax earnings); that's 50% higher than here.  Again, this is what Buffett would be willing to pay.

Yes, but... 
I know.  Many don't see current bank earnings as sustainable.  Reserve releases and a friendly Bernanke is really helping the banks (although we can argue that buying bonds is not helping banks as it flattens the curve (offset recently by a refinance boom that is tapering off)).

On the other hand, one can see the economy as still very subdued and not really recovered.  Housing is still running way below historical trends, and of course, the interest margin is arguably at an unnaturally low level that would eventually normalize.  Also, legal and other costs are elevated due to legacy problems from the financial crisis.

Anyway, let's take a look at what JPM says they can earn on a more 'normalized' basis from their investor day presentation earlier this year.

JPM has long said that under a more 'normal' environment (escalated credit and legal costs come down etc.), they can earn $24 billion in net income.  This is the slide from the investor day presentation that shows this:

This is assuming no change in the environment, but just a normalization of the recent big items.  Just for reference, the last twelve months net income for JPM came in at $24.4 billion.

And another slide showed there are growth initiatives that should allow JPM to earn more than $24 billion over time.  Dimon didn't say when earnings would get to $27.5 billion shown below, but said that the initiatives are close to being in place or will be in place soon so are not longer term targets, so he hinted that $27.5 billion can come soon too.  This is not some medium/long-term project/target.

Using the $27.5 billion ''normalized" figure including growth intiatives and $1.3 billion in benefit from a 100 basis point increase in interest rates, that would come to $39.3 billion pretax (assuming 30% tax rate), and deducting $1.5 billion for preferred dividends and "dividends and allocation of undistributed income to participating securities" leaves us with $37.8 billion.   With 3.8 billion shares outstanding and a $56 stock price, that implies an 17.8% pretax yield.  That's pretty interesting.

Again, not wearing rose-colored glasses, but borrowing Buffett's glasses, it looks like Buffett would be willing to buy JPM up to $99/share!  That's 77% higher than the current price of $56.   Another way to put it is that JPM is trading at 60% of what Buffett would pay for it.

The reason why I went back to these slides is to show that recent trends is within what JPM considers a normal range of earnings.  Even though JPM had great earnings due to reserve releases that can't go on forever, it shows that earnings can grow even without that as other areas 'normalize'. Banks may be benefiting in the short term by dramatically improving credit trends before other areas pick up, it doesn't mean that earnings are unsustainably above trend.   Of course, if other areas don't pick up, then recent trends may be unsustainable.

But, but...
Another big issue, of course, is the leverage ratio.  A lot of questions on conference calls is about leverage ratios.  This is obviously a factor.    Many seem to think that higher leverage ratios will mean that banks can't make money as they did before.  But I think this is not linear, necessarily.  There will be an impact for sure, but these will be priced into bank products.

For example, if a bank had 1% return on assets and had a leverage ratio of 5% and therefore earned 20% on capital and then suddenly the minimum ratio was bumped up to 7%.   This will obviously reduce the return on capital from 20% to 14%.  But what will happen over time is that banks will reprice their loans/products such that they make a reasonable return on capital.  In the above case, the banks would have to earn 1.4% return on assets to make a 20% return.   Loan prices would have to rise 40 basis points (actually, loans would be only a portion of total assets so other assets would also have to increase 40 bps).

This is just an example using random numbers to make a point so not realistic.  I may take a closer look once the dust settles on the rules.  I don't think loans/products will reprice immediately to maintain return on capital, and I don't know if they will be able to reprice to go back to the old returns.  But things will move in this direction.

A key point to remember is that this rule will apply to all big banks, so repricing should happen across the board.  It's just another increase in the cost of business that will eventually be passed on to the customer.  In that sense, this will have implications for monetary policy, of course, similar to raising the fed funds rate.

The problem, as Dimon pointed out, is if the U.S. has a more stringent leverage rule, it may put U.S. institutions at a disadvantage against other global banks.

Rising Interest Rates
The other issue is rising interest rates.  We can't really argue both ways.  We can't be upset with decreasing long term rates as it puts pressure on NIM, and then be worried about rising rates because that will kill the refinancing boom.

What do I think?  Well, I like WFC, JPM and other financials, but it's not conditional on interest rates.  For example, I don't say I like JPM with treasuries at 2.0% but hate it at 5.0%.  This really makes no sense to me.  I've been involved in the markets for a long time and I've seen all sorts of interest rate forecasts so the last thing I would do is invest based on a view on interest rates.

(At a firm I worked, I laughed at the resident economist who said that the Fed Funds rate will go down to 5%.  It was 8% at the time.  And then he said it will go to 3% and then I laughed even harder.  etc... You get my point.)

I like these well managed financials because, well, they are well managed. It's not because I think interest rates will stay here, go down to 2.0% or won't go above 3.0% or anything like that.  I have confidence that the management at good banks will do what is best in each respective scenario; I will let them worry about it. If I didn't think they could handle fluctuating interest rates, I wouldn't own them.  And they have been stress tested. Not by the Fed or a regulator, but by a serious financial crisis.

Off-Topic Tangent
OK, so the above thought on interest rates reminds me of a conversation I had recently.  I was talking to a guy who is really into value investing.  He is and has been studying value investing for a few years and it's his main passion/hobby (not his main job).  So I emailed him a whole bunch of stuff including book recommendations, told him to make sure to read Buffett's letter to shareholders, the article "Superinvestors of Graham and Doddsville" and the other usual stuff that we all read.

Then a few weeks later, during the market decline in June, I ran into him and he was very excited because he told me he sold out right before the sell-off  (I saw him the other day but didn't ask him if he bought back in...).

Well, he did tell me that he is a value investor and not a trader so I was a little surprised.  How can you do all the work and analyze companies, buy them and then just turn around and sell them just because the bond market goes down a little?  If you evaluate and like a business with treasuries at 2.0%, you should feel comfortable owning it with treasuries at 3% or 5%.  If not, then maybe it's not such a great business.  If you won't like a business if rates go up, then one simply shouldn't buy that business to begin with (because rates will go up, eventually).

This also reminds me of a cardinal rule of trading; if you buy something for one reason, don't sell it for another.  Of course, unless the other reason is a really good, valid reason to sell a stock (fraud uncovered, unfavorable management change, long term decline or permanent impairment of business etc.).

Anyway, time and again, I run into people who love and own this or that stock, but then they later tell me they sold because they feared a U.S. debt default, fiscal cliff, meltdown in Greece, bond market crash or some such thing.

Buffett wrote a comment (which Seth Klarman also said) in the "Superinvestors of Graham and Doddsville" article that this value investing idea is something people either get right away or not at all.   Time and again, people will do one thing (rational) and then out of fear or greed turn around and do something that makes no sense. He is so right.

If you do all the work, read the annual reports, 10-k's, 10-q's, understand and like the business and the valuation, then go ahead and buy the stock.  But please don't sell the stock just because everyone says that the bond market is going to crash and that stocks will follow it down!  If a company you are looking at is going to go bankrupt if a recession hits or if interest rates go up to 5%, then the right thing to do is to not buy that stock to begin with.  Don't buy it and try to sell out before the next recession or before rates start really going up because that sort of strategy doesn't work unless you are a really good macro trader (and those are rare!).

Yes, there are people who make a living doing macro trading.  But macro traders spend all of their time looking at macro trends and placing bets according to their own deep analysis of what they think is going on. It makes no sense for value investors who spend their time looking at businesses and financial statements to be a value investor one day and then a macro trader another (buy a stock on business fundamentals one day and then sell on another day for macro reasons).  When you really think about it, the sudden turning of value investors into macro traders is usually emotionally driven (fear), not by logic.

If you look at the great wealth created over time, most of it is created by people who buy and hold good assets; it is not created by dancing in and out of holdings (especially motivated by things that are simply unknowable).

But I know, I am preaching to the choir, but I can't resist as the above scenario happens to me all the time (and I'm sure many readers have the same experience).

I still like the financials.  My only reservation is that they are getting more popular.  But valuations are valuations and they are reasonable.  I looked at WFC and JPM from a slightly different viewpoint from what is common (usually looked at on a P/B or P/E basis) and find it interesting.

There are obviously a lot of risks here.  Interest rates can turnaround and head down and really continue to push NIM down and the economy can stay here or deteriorate making banking a horrible business.  Inflation can pop up and make rates go up in a bad way.  If rates go up due to a strengthening economy, that would obviously be good for banks regardless of what happens in the short term.  Over time a stronger economy would increase loan volumes and help other areas and rising rates would get NIM back up and increase profitability.


  1. Very interesting as always. Banks are way outside my circle of competence, but isn't there still a lingering concern that these banks have latent risks on their balance sheet that they are not disclosing? I take your point that they were stressed tested by the financial crisis but don't they still hold nasty derivatives that could bring down the house of cards?

    1. Good point. Bank balance sheets are really impossible to analyze from the outside. Apparently, it's hard to analyze even from the inside given what's happened in the past decade.

      Banks, insurance companies and many other businesses really come down to the management. Even with Berkshire Hathaway, we really have no idea what kind of risk is on the balance sheet. Even the foremost expert on BRK can't tell you the detailed exposures in their insurance book. But we are comfortable (I am not an expert on BRK but...) because we feel like we understand the culture of BRK, Buffett's personality and that has been confirmed/proven by historical performance.

      This is the same with analyzing banks. Sure, JPM has a huge derivatives book and I have no idea what's in there. But I do feel like I understand Dimon and how he really hates risk. I do know people who have worked under him and he is the real deal. He has a nose for risk. Yes, he messed up with the whale loss; he leaned too hard on a trusted subordinate.

      But at WFC and JPM, they have proven time and again that they are on top of things and wouldn't do stupid things and take stupid risk for a little more money.

      My career was in the financial industry so I do have a comfort level that many others probably don't, particularly after what happened in the recent past.

      The other factor that makes me comfortable is that I already had this confidence in JPM/WFC and some others before the crisis so the real-life stress test was sort of an out-of-sample test for me that proved I was right. I would tell anyone who would listen that despite most people saying that JPM would be the first to fall in a financial crisis due to the size of it's derivatives book, I thought JPM/WFC would survive without a problem.

      I had no doubt that Bear Stearns and Lehman would be the first to fall. I also had a lot of confidence in Goldman.

      Again, this comes from years on the street and dealing with real people who have worked at these firms, hearing about what it's like working there, the culture, how the company operates etc...

      And they all pointed to the same thing; Bear and Lehman are dangerous, Goldman and JPM are solid.

      So this is not something I concluded *after* the crisis, but something I strongly felt *before*, and was proven.

      Having said all that, yes, there is still all sorts of risk in financials. I would never be comfortable with anyone putting 80% of their net worth into JPM, WFC or GS. I would have no problem, however, with someone putting 80% of their net worth in Berkshire Hathaway, for example.

      Anyway, this is just one of those things where the investment process is cumulative; all of your experiences and what you learned in the past help you to make decisions currently. And a lot of this stuff doesn't translate well into some spreadsheet or any presentable 'fact'.

      Thanks for reading!

    2. This comment has been removed by the author.

  2. Thanks for the post.

    Financials are outside my circle of competence. Your posts on financials have been my education. But I'm not sure at what point I'll "graduate" to put a real stake in them. Looking at those hundred odd pages 10K's just makes my head spin... Too many moving parts. Too many assumptions. I think Buffett is right that buying banks is trusting the mgmt.

    One thought I have is: can I take a portfolio approach, skip the analysis but just buy the cheapness? Buffett famously did that in Korea once in the past. Say, can I buy a small portfolio consisting of JPM, BAC, and AIG without really understanding the economics of their businesses or reading their 10K's? BAC and AIG trading at 60-70% of their BVs are tempting. But I have no idea how much I can trust their books.

    Interested in your opinion.

    p.s. Have you told your friend to keep a journal?

    1. Hi,

      Yes, you can take a portfolio approach, I suppose. I would tend to save that sort of thing when things are really cheap, though, like back in 2008 or early 2009.

      Otherwise, my interest in banks now are more specific to these great managements.

      But you would have to really have confidence in banks and that things will turn out well over time or else you would just end up selling them out in panic when the next crisis or 'scare' happens.

      Owning a small basket is fine, but again, if you don't have some confidence, you will be uncomfortable when nasty headlines appear. What are you going to do? Without some sort of confidence, it will be hard to deal with things like that, I think.

      I think portfolio approach is fine, but then again, no need to force the issue either. If you aren't comfortable, you aren't comfortable. That's fine. Plenty of great performance numbers have been put up without owning any financials.

      Oh, and no, I haven't told my friend to keep a journal. That's a great idea and I should mention it to him next time I see him.


    2. (Lack of) confidence... hmm... damn... I'm the easiest person to fool...

      Yes, spot on. Thanks!

  3. KK,
    If you are going to the coming LUK shareholder's meeting, I would appreciate very much if you could share your notes with us afterword. This year's meeting should be very interesting as it may shed some lights into the future of LUK.

    1. If I make it, I will post my notes. Thanks for reading.

  4. KK,

    I'd like to get your opinion on the loan book of some players, like per say JPM. One observation from the field which I'm noticing is obviously the ultra thin pricing on corporate loans (both IG & leveraged names) combined with the lack of decent underwriting as personnel (credit and sales/bankers) are pressured and paid for asset growth and fee income. The trend seems like indifferent at both super-regionals and bulge brackets.

    The above experience has really changed my perceptive on banking for the moment, unless they trade at a fairly nice discount to BV.

    On another note, since you easily have one of the best value investing blogs out, I'd def. like to learn more about your experience on the street.

    1. Hi,

      I don't have any color on specific loan books. What you say doesn't surprise me at some level, but I would be surprised if JPM was making reckless / bad loans. I have been following Dimon for years and they do occasionally get involved in the bad deals, but Dimon usually hates bad products/prices. But it's certainly possible that some areas are getting thin in terms of pricing and underwriting discipline.

      In any case, yes, banks aren't as cheap as they were.

      Thanks for your comment about the blog. My background on the street has involved investment research, special situations / proprietary trading, derivatives trading / product structuring and work at one of the top hedge funds generating trading ideas etc.

      So my experience is more from the trading side than the investing side.

      Thanks for reading.

  5. Buffett say's he's willing to pay 9-10x pretax yield, but he must be talking about EV/EBIT. Using MC/EBIT doesn't make any sense. He'd start buying companies with massive amounts of leverage on that measure. If we're going with marketcap, it also means he's willing to buy all companies trading below a PE/(1-tax rate) < 10. Using a tax rate of 30% gets us to any company with consistent earnings trading below a PE of ~14. That hardly sounds like he's waiting for the right pitch. I remember reading somewhere that Buffett used to love paying 7x EV/EBIT for consistent earnings back in the day.

    Also, we should perhaps reach for a higher yield than 10% (EV/EBIT), given that we don't have $1B of earnings to reinvest every month. I mean to say that we should maybe set a higher bar than what Buffett is setting for BRK. His alternative is to pay a dividend, which would get taxed, or earn next to nothing sitting on cash.

    1. Hi,

      You are right if you use EBIT, but my pretax figures are after interest expense and preferreds and some other deductions, so what is left is specifically for common shareholders. So it is fine to compare to market cap. It's either EV/EBIT, or market cap/pretax earnings (less preferred dvd. Pretax earnings is already after interest expense).

      And yes, a pretax 10x is 14-15x p/e. That is basically the long run average p/e for the market, so a better than average company at that level makes sense.

      I agree that the enterprising investor has a much bigger pool of potential investments for sure. Most of us should have an investment hurdle much higher than that.

      But my frequent posting about big cap financials is driven largely because it was a contrarian play back in 2011 when I started this blog and I had a comfort level with them that I felt many didn't have and I had a lot to say about them. Investors hated them, analysts hated them (most of the most prominent analysts were telling people to stay away), the public hated them (may still hate them, but this was when Occupy Wall Street was going on) etc...

      Now they are still interesting but are getting into the range of more 'normal' investments to be sure.

      Anyway, thanks for reading!

  6. Someone posted a comment about AIG; I got the email alert on the comment but it didn't show up here for some reason.

    Anyway, AIG is definitely an interesting idea and it is cheap for sure. I stuck to the banks/investment banks simply because for me, the path to a higher ROE was much clearer to me. JPM was earning 15% on tangible book for a long time and it was trading at tangible book not too long ago. That to me was more interesting than something trading below book but with sub 10% ROE with no clear (to me) path to a 10%+ ROE.

    So it's just a preference thing. I was just more comfortable that banks could get back to or retain higher ROE's than insurance companies at this point.

    Thanks for reading and posting.

    1. KK,

      that was probably me. I checked back two or three times and then forgot about it / got swamped with other stuff. Some other blogger using blogspot mentioned that on times the spam filter is a bit too eager, so maybe it ended up there. I just couldn't reproduce the whole litany from the top of my head.

      Anyway, great stuff !



  7. I've read with interests a couple of your posts mentioning that Mr Buffett would be very happy with good investments providing a 10% pretax return, but is it possible you've missed the key point that this means 10% pretax in the hands of Berkshire Hathaway, not 10% pretax at the level of the investee firm?
    i.e., 10% before the taxes that Berkshire pays but after the taxes that (say) Wells Fargo pays.
    Berkshire is indifferent as to whether those after-tax-at-the-investee-level earnings are retained or paid out as dividends, but it's WFC's or JPM's after tax earnings that determine BRK's pretax yield.

    1. Yes, that's a good point that I did think of. But I think Buffett looks at stock holdings as if he owned the whole thing. If he was able to buy all of WFC at the current price, then the pretax yield would in fact be 12% or whatever it is I said.

      So that's the way I look at it.

      Also, I do remember checking at the time Munger made his comment (I think it was before the crisis) and I think WFC did trade at 10x pretax earnings or something like that.

      I looked at asset managers not too long ago here as a group and they were all pretty much trading at 10x pretax earnings too, so however we interpret Buffett's comment, there are enough data points that make me comfortable that it may not be too far off from how he looks at things.

      Thanks for reading and posting.

    2. "If he was able to buy all of WFC at the current price, then the pretax yield would in fact be 12% or whatever it is I said. ..."
      Well, um, yes, I like the analogy, but it wouldn't be.
      If he were able to buy the whole company there wouldn't be an extra level of taxation. Upstreamed dividends are tax free from a wholly owned subsidiary. The difference in earnings yield between the two situations is exactly equal to the difference in the target yield that would be required for a rational investor in a company valued on earnings yield considering a minority stake and considering a complete buyout. Mr Buffett's comments about "if I'd like to own the whole company then I'd like to own the shares" are speaking, I believe, much more about the qualities of the company in question than a threshold price per share.

      In good years Wells Fargo's tax rate is north of 40%, so a 10% pretax yield hurdle for a minority-stake buyer means a hurdle rate of 16.7% pretax at Wells Fargo's level to buy the shares. That's a big difference. Clearly Berkshire hasn't had that many opportunities to buy Wells Fargo shares that cheaply. So what gives? It's not the earnings yield hurdle that needs redefining, it's the valuation approach.

      Earning yield and EPV valuation isn't really the right way to value Wells Fargo as it's one of the very few firms able to deploy meaningfully large amounts of new capital at high rates of return. The sort of valuation approach that more makes sense (and no doubt something more akin to Mr Buffett's thinking) is the ratio of the very conservatively estimated earnings in ten or fifteen years to the price paid today. More likely he simply looks at his estimate of size of and returns on newly deployed capital in the next decade or two, which amounts to the same thing indirectly.

      Where does the "10% pretax earnings yield into Berkshire's hands" rule of thumb apply? Acquisitions. The vast majority of good firms with economic moats are not able to allocate large amounts of new capital within their franchises and are therefore more meaningfully valued on their cyclically adjusted earnings yield, more akin to the slower growing among Berkshire's operating subsidiaries. I believe that's the sort of context in which the "10% pretax" comments were made. Again, those would be 10% pretax into Berkshire's hands, as in the case of a wholly owned subsidiary, which would be taxed once at Berkshire's rate then become grist for the capital allocation machine. By extension, given Berkshire's ~35% tax rate, as a rule of thumb he'd like a unit to generate 6.5% of its cost in after-all-levels-of-tax cash to be reallocated---there or elsewhere, wherever has the best bang.

    3. I see your point and it's a good point.

      But I don't think Buffett actually values things this way, even if it is 'correct'. I don't think his hurdle is going to necessarily account for the double taxation.

      Why not? Because I think he wants to invest in business, as you say, that can reinvest over time and in that case, he wouldn't really have to worry about the double level of tax (except for what gets paid out in dividends).

      Whatever gets reinvested and grows will be reflected over time in increasing share price, and as long as BRK doesn't sell any shares he will pay no taxes. He gets a free loan from the U.S. government on the tax he owes.

      So, for example, if Buffett did his work on after-tax returns, I am not so sure he looks at things on a basis of 0.6 x 0.6 (assuming 40% tax rate) basis.

      In that respect, as long as he is not actually going to have to pay the second level of tax, he may just look at pretax earnings as pretax earnings.

      But I do get your point. After tax returns will differ for sure depending on if you are an OPMI or a full owner.

      Thanks for the discussion. You do raise a good and valid point.

    4. By the way, to put it differently (to say the same thing I already said), the intrinsic value of something is what a rational private business owner would be willing to pay for something. Never mind for now that nobody is going to buy WFC.

      But I think businesses are often valued at what a private owner would pay for it, and on that basis, 10% pretax still makes sense as buying treasuries yielding 2.5% is also a pretax return for a private owner.

      I guess the problem for this private business owner might be getting that 10% pretax return to himself as he will pay corporate taxes and then some sort of tax on distribution when he pays it out to himself personally.

      But at the corporate level, they would both be comparable. In real life, he can buy bonds directly and suffer only one layer of tax.

      This veers off of Buffett's wanting to earn 10% pretax, though. But I don't think it's completely off base.

      Anyway, interesting discussion. I agree with you on many of your points.

  8. You mention in the comments about needing to make a judgement on management at the various banks given that understanding the balance sheet is so difficult. How best can average Joe educate themselves to make that kind of judgement? Just keeping up to date with the financial press?

    Out of interest, what's your view on Barclays? Particularly since Diamond was ousted.

    1. Hi,

      Yes, just keeping track of the various banks is the best way to go. Read the annual reports going back as far as you can, read articles about them and books about the bank and/or management/CEO. If you have time, listening to the earnings conference calls as often as you can can give you a lot of insight to management; how they see the environment, how they are responding to it, how they are doing versus competitors, how they react to questions from analysts (do they sound like they are on top of things? Are they defensive and incompetent sounding? ).

      Also you can see how they do in bad times. Are they aggressive in their accounting? Conservative? Do they tend to jump into faddish areas and then take huge write-offs? Is management in it for themselves or do they want to create a great organization?

      So there are many ways to learn about management, the bank and it's culture.

      Buffett also advocates going back and looking at what management has said over time and seeing if they were able to accomplish what they said they wanted to do; this was key in Buffett's purchase of IBM. It wasn't the only factor, of course, but a big one was how he liked how IBM set out a plan and achieved it.

      The more familiar you get, the more 'feel' you will get and be comfortable in making a decision. After that, it's about price etc...

      As for Barclays, I have no particular view. I haven't been following it, and I've also never been a particular fan of Diamond.

      Thanks for reading and posting.

    2. Thanks for the useful and quick reply.

  9. Thanks for the insights!
    I was never a big fan of the financials prior to the crisis, but after the past years I've begun to like WFC and JPM more and more. I'm also a young and still learning value investor myself, recently came back to Asia after graduating from college. I have learned a lot from you over the years, so just want to say thank you here.
    Jamie and WFC are two of my favorite stocks now, and have been buying over the past year. Although I am starting to fall into the mentality of "it'd have been a great investment if it's 10% cheaper." I know I am making a mistake here. Just like my case now for DTV, banks (if well-managed) are able to constantly grow its intrinsic value at a good rate, not to mention the great franchise of JPM/WFC present great brand equity that's not priced in yet. I love all these three stocks and I am perfectly fine with paying a little premium to great businesses.

    Thanks for the post again!

  10. Hi KK,

    I’ve been reading your blog recently but admittedly am not an expert on banks and financials. I recently started working at a retail bank and admittedly don’t know too much about valuations within the industry. I had a few questions that I was hoping you would be able to provide some commentary on at some point on your blog, if you feel so inclined.

    1. I’ve heard often that Buffett says the bank with the lowest cost of capital will be the winner.
    a. Is the idea that either they can get larger margins on their assets, or give them more flexbility when pricing starts to get overly aggressive/stupid within industry?
    b. How do you measure cost? Is it simply the average deposit rate, or fully loaded costs? Does this change dramatically now that online banking like ING Direct is incredibly scalable and has minimal physical overhead?

    2. Should one view banks similar from the perspective that Buffett took with insurance to gain access to float?
    a. If so, should one then look at the cost of deposits as the cost of float and then their various lending businesses as the “investment opportunities” that Buffett similarly had with his insurance investments?
    b. How do you measure the value or value add of the actual deposit banking side versus the various investment options on the lending side like credit cards, mortgages, etc?

  11. Hi,

    Buffett says that in any business, the one with the lowest cost will win. Like Walmart. Costco. In banks, the primary input (cost of goods sold) is cash. So I suppose you can look at the cost of funds and obviously cost of operations will matter too. The one with the lowest cost will survive when times are bad and pricing gets worse, and they will make the most in good times as they make a bigger spread.

    As for ING Direct, I thought the internet would make bank branches obsolete too, but over the years JPM has opened a lot of branches and Dimon says that every time they open a branch, they get a lot of new deposits and that leads to other services sold (credit cards, mortgages etc...). So I think people still want to bank at branches. Probably over time, this may change, but it looks like branch banking is still very profitable.

    I don't know what ING Direct has to pay, but if they are gathering deposits by advertising higher rates than your local bank or big banks, I don't know how they compete with a higher cost. If they pay lower, then I don't know why people would send money to an internet bank that might not provide the services that you can get from the big banks or local banks.

    But having said that, I don't know anything about ING Direct.

    As for question 2., I do think it's similar to insurance companies and the concept of float. The way you look at the value added is to look at the deposit margin, net interest income and things like that. You can see all of this in great detail in the 10-K / annual reports of banks. They are very, very detailed... what the average interest paid on savings accounts is, what they get for mortgages etc... It's all in there.

    But the big thing, as usual, is management / culture etc... You have to see how the various banks performed in various cycles. Are they conservative? Do they do dumb things? Do they make tons of money in good times and lose tons of money in bad times? etc...

    Look at the track record of the management.

    Thanks for reading!

    1. Thanks for the quick reply - tons to think about.

      With ING Direct my thought is you have an online platform to service accounts, which is a huge fixed cost. Many traditional banks also their own online platform, in addition to the capex + opex costs for maintaining branches. I took a quick estimate by googling for ~10 minutes and got the following numbers.

      Deposit per branch - estimated using data from around 2004 (may be dated but seems roughly reasonable): BAC = $85M, JPM = $145M, WFC = $76M. I assume most of these are for mature branches and that it would take a few years for new branches to reach anywhere near this level.

      Another search shows estimates for up to $2M in cost to open a branch, and another source shows Opex for branches with $60M+ to be about 60bps of deposits. It seems like there is a lot of cost advantage an online platform would have and that such a business would a decent amount of operational leverage.

      I'm thinking their biggest disadvantage may be on the lending side, especially in light of your prior post on WFC and how many products/relationships they have with the average customer. We'll see how that develops as there seem to be more and more online lending channels like Quicken Loans.

      I know this doesn't point to a specific number or estimate of value for something like ING, as I haven't done that much research or thinking, but just wanted to share some of my initial thoughts.

    2. Hi,

      Yes, online has a lot of advantages for sure. This is similar to what happened with full-service stockbrokers versus cheap online brokers. I think they were two different markets for a long time. The wealthier people with bigger portfolios tended to stay with full-service while the low balance, self-directed investor (and younger) tended to go for the online discount broker. You can probably google it, but the average account size in each told the story pretty well. I think this difference breaks down over time, though.

      Banking might be similar. If you look at some JPM presentations there are slides about the branches, return on investment and things like that.

      What you don't see in some of your figures is the new business they generate every time they open a branch in a given neighborhood.

      I also wondered about branches in the Amazon world and seeing restaurant and store-owners schlepp big bags of cash to the nearby branch reminded me that some people appreciate branches located nearby... (this too will go away as the world goes more and more cashless).

      Anyway, eventually the world may become a branchless one but for now it still seems to be a profitable business for the banks.

      As the world changes, banks will evolve too.

      Anyway, this is an interesting discussion and I wonder about branches too, sometimes...

  12. Can you say again what metric to use to determine which bank has the lowest cost of doing business?

    Is it net interest margin?


    1. The common measure for cost efficiencies in a bank is the efficiency ratio, which is non-interest expense as a percentage of net revenues. Buffett talks about cost of funds; the lowest cost wins.

    2. Thanks for being so generous with your wisdom

      I am from Australia and here the big 4 banks have a relative oligopoly...They list their ratios as "cost-to-income" ratio which is expenses as a % of total income (net interest income + non-interest income).

      Here are the results:
      ANZ 45.0%
      CBA 42.9%
      NAB 49.5%
      WBC 42.8%

      Are these small differences significant to suggest one is cheaper than the other?

      Our tier two banks have much higher C-to-I ratios;
      Bendigo bank 57.8%
      Suncrop bank 53%
      Macquarie bank 70%

      Is there any calculation to infer the valuation of a bank's stock based on C-to-I ratio or is it just a measure of the cheapest?


    3. Hmm... efficiency ratio or cost-to-income really doesn't have much to do with valuation of a bank stock or how cheap it is. It only shows how efficient it is. For cheapness/valuation, you would need to look at P/E ratio, P/B (price-to-earnings, price-to-book) ratios etc...

      There is no one measure that will tell you if a bank is cheap, but the above two are very common things to look at. You should look at both of those, and other things too.

      The efficiency ratio will differ according to what kind of bank it is, small regional, big money-center bank, pure community bank or a bank that offers other services like investment banking, stock brokerage etc...

      To look at a bank, one important thing to look at is the ROE (return-on-equity) and see how efficiently the bank uses equity capital. Also you have to see what kind of leverage it uses to get it (or what kind of risks it takes), so knowing the character / culture of the bank/management, to me, is the most important thing.

      Also crucial is to go back and see how the company did in bad times. A lot of banks lost tons of money in the recent crisis. That's usually a warning sign, unless the management has changed completely, or there is some other mitigating factor.

      So ROE, character of management, how the bank has done over time and especially in bad times along with the usual valuation measures of P/E, P/B etc. are good starting points to look at. There is no ONE thing that you can look at to tell you anything...

    4. What a reply! thankyou

      But do you think that a cost-to-income ratio difference of <5% is significantly different to say one bank is more efficient than the others? All 4 are big banks

    5. I don't know... It really depends. You can't really just look at one number and come to any conclusion about anything at all.

  13. OK thanks

    What about for insurance companies? Buffett has said the lowest cost provider wins. Is one metric best or all 3 are important? (Expense ratio, Loss ratio, Combined ratio)

    1. The answer is still the same. You have to look at everything. If there are differences, you have to figure out why. Even if costs differ by 5% as in the above bank example, you have to figure out why costs differ so much.

      Insurance companies too will have different levels for all the metrics; auto insurers versus specialty insurers vs. reinsurers etc... The exposure to the different areas will show up with different total combined ratios etc...

      You have to look at the how insurance reserves have devloped over time (look at the reserve triangle in the 10-K etc...), look at the management; are they conservative? Are they aggressive? Are they good underwriters? Good asset managers? How much investment leverage do they have etc...

      There are a lot of things to look at. Investment is a process of digging into these things, not just trying to figure out what that one, two or three important metrics are.

    2. Thanks that makes a lot of sense and is sound common sense

      Do you think reading annual reports is a good way to dissern that? I have just started reading the 2015 one and that is hard enough let alone going back from 10 years and forward. Its hard to find the answers to those questions I think so I'm still trying to find the right place to find it

    3. Yeah, the annual reports are great for that. Make sure to read the 10-Ks too. Earnings conference call transcripts are useful too to figure out what people are looking at, worried about etc. and get a feel of the kind of people management is.

      As Buffett says, investing is like investigative journalism. Just figure the company out; how it works, how it makes money, how the management is etc... If you keep doing that, over time, you will begin to understand all sorts of things. And then single metrics will start to make sense too because everything else will be in your head as background information.

      I often boil things down to just a P/B or P/E ratio, but that's after all the work I've done over time and that's why when I say I like A at 1.0x P/B and someone says, well, what about B at 0.6x P/B, most of the time I still like A at 1.0x P/B better etc... (There is a reason why Buffett doesn't just go out and buy the cheapest P/E or P/B stocks even though as quantitative basket strategies, they seem to work over time).

  14. Somebody linked your article today on Twitter. I was interesting to look at what happened since. The price is approximately back at the same level but the quarterly pre tax income continued to rise with last q being around 9bn after prfd divs which results in a 15% pretax yield if taken as a run rate. It is obviously anybody's guess how much long term damage the recent scandal has caused to the retail franchise. My guess is any damage is rather short term and limited as these fake accounts and credit cards didn't generate any revenues but only costs. The shine is certainly off for now and people question whether it really deserves that much of a premium valuation. Investors now probably want evidence that the pre-tax yield can be sustained. Once it is clear it will probably be too late. Bank franchises are usually much more sticky than people expect. After all, it is a real hassle to change banks, open new accounts etc... I guess we need to wait for Q3 results and some guidance.


Note: Only a member of this blog may post a comment.