In a September 10, 2008 article, I presented a ranking system designed to identify more prudently-managed banks, and noted that for most years, it had not worked: Such stocks did not outperform those of the more aggressive institutions.
The model had, however, performed very well during the recent collapse, as risk-aversion became the new mantra.
Looking ahead, I suggested that
it seems reasonable to assume this model will cease to identify better-performing bank stocks once investors start looking past the crisis. In that case, when the lesser-rated stocks outperform improve (or even improve substantially relative to) higher-ranked stocks, one might take that as a signal that the bank group as a whole is more buyable.
That's exactly what's been happening lately, so there's a lot of pressure on the banking sector, with stress test results soon to be formally announced, to meet lofty expectations.
Learning from history - not really
I believe the banking crisis has been quite straightforward. Forget about derivatives. Forget about structured investment vehicles. Forget about securitization. Forget about hedge funds. It all boils down too this: Too much money was loaned to too many people who had no plausible chance of ever repaying. The derivatives, etc. served only to help give the latest crisis the specific flavor it had. But even if none of those things existed, there still would have been some sort of calamity. The details would have differed, but we'd have still had a disaster.
There's nothing at all esoteric in the way many bankers approached their business. What happened was the inevitable result of a lot of deliberate strategies. What, after all, could any rational banker expect . . .
- when an institution launches a no-income verification loan program (in other words, deliberately avoids examining creditworthiness);
- when a traditional mortgage 20 percent down payment requirement is relaxed to 10 percent, to five percent, or even to zero;
- when loan monthly repayment obligations are allowed to soar to unprecedented highs relative to disposable income;
- when banks build an interest-rate escalation into a loan that already exceeds the borrower's ability to repay;
- when home prices soar to levels that would make former Dutch tulip traders wince (could they really be so confident in the valuations they put on the security interests that supported mortgage loans);
- etc. etc. etc.
Such behaviors suggest far greater concern fro growth than solvency. And they leave financial footprints that can easily be tracked by one seeking to rank evaluate stocks.
Ranking bank stocks based on strategic prudence
Here are the factors I used to identify conservative banks:
- Trailing 12 month growth in Interest Income: For banks, this is the equivalent of sales growth. Unlike most equity models that favor higher growth rates, this one favored the slow growers, the ones who were willing to forgo new loans when same could not be made on prudent terms. Of course, even prudent investors may not wish to get too carried away. We don't want to be so prudent, that we just hide in our bedrooms forever. But here, lesser growth does not stand alone...
- Trailing 12 Month Lending Margin: This is net interest income divided by interest income. The difference between the two is interest on deposits, borrowings and securities held. Arguably, the conservative investor would be more interested in seeing the margin after deduction for the loan loss provision, but I elected not to do that here, since the latter data set is likely to be especially volatile nowadays. The ranking system favors banks with higher lending margins. Combining this with the way I treated growth, the model is more interested in banks that lean toward slower but profitable growth, as opposed to those who slash margins to "buy" lending share.
- Equity Multiplier: This is total assets divided by equity relative to other banks. The model favors lesser tallies, which signify lesser tendency to use leverage. Of course all banks use leverage as a matter of course. That's why this factor is ranked only relative to industry peers.
- Trailing 12 Month Return on Assets: This is a classic measure of overall corporate profitability, and consistent with normal usage, higher tallies are favored here. For industrials, I'd be more likely to use Return on Equity of Return on Investment. But for banks, it's more useful to look at the entire asset base, especially since this model includes the equity multiplier and, hence, is not ignoring the issue of leverage.
The factors were equally weighted.
Back-testing the system
Figure 1 shows a portion of the set of Portfolio123.com backtest results I presented back in September. The period studied is 3/31/01 through 12/31/06, when return seemed to have been exalted over risk. The left-most red bar represents the annualized performance of the S&P 500. The second, blue, bar represents the banks rated in the bottom 10 percent, The right-most green bar depicts the annualized performance of the banks stocks rated in the top 10 percent.
Figure 1: 3/31/01 - 12/31/06
Clearly, risk aversion was not on Wall Street's front burner during that period. What was? Probably upward estimate revision, growth, the usual litany. (I'd have to create another model to be sure.)
Figures 2 shows what happened in calendar 2008, the disaster year.
Figure 2: 12/31/07 - 12/31/08
It's not perfect. But the separation we see between the most conservative and aggressive banks makes it clear Wall Street got religion.
However, Figure 3 shows that prudence may have been a passing fad whose time has come and gone.
Figure 3: 3/1/09 - 4/28/09
Evaluating the situation
Is this simply a matter of bottom fishing for losers at a cyclical trough? It's possible. It's been done before, probably a gazillion times.
But that only works if there's meaningful and lasting change: a reason to expect that the factors which damaged the stock in the past won't likely return. Often, a transition in the business cycle can, by itself, be sufficient. But that ought not suffice here. Arguably, overly-aggressive banking practices caused the cycle to turn out the way it did, so if that's not seriously changed, a cyclical upturn might prove fleeting.
Traditionally, we also look for lasting change in the way a company approaches its business: product decisions, labor-relations management, cost efficiencies, marketing strategies, and so forth. Some busted companies rise from the ashes and then, fall down again in the future. We've seen it with airlines, and autos for example (this is not the first time automakers have come to Washington hat in hand).
Big-name banks that were most aggressive in the past include such familiar names as Citigoup (C), Bank of America (BAC), Wells Fargo (WFC), PNC Financial (PNC).
Are they REALLY going to change their stripes? Right now, Big Brother in Washington is watching, so for a while, they need to behave. But will it last? Or, might Big Brother even decide we really need to boost lending more aggressively and simply diminish scrutiny as the news cycle moves on to something else? (Speaking of Big Brother, did it push Bank of America into a mess by "facilitating" a shotgun wedding with Merrill. There's still much to be learned going forward.)
It's hard to answer such questions at this point in time. So if one is going to plunge back into bank stocks, it may be worthwhile to give at least some consideration to the more prudent (higher ranked) names. Three S&P 500 banks were ranked in the top 10% for prudence: First Horizon National (FHN), Comerica (CMA), and SunTrust (STI).
Disclosure: No positions