Of Banks and Bottoms: Not Yet

We often get asked if we see value in some banks at these depressed levels. We don't approach stocks from a timing point of view, but rather from a value point of view. Unfortunately, it is just too difficult for us to determine the intrinsic values of these "black boxes", for several reasons.

First of all, determining the value of the assets of these institutions is a guess at best. As we've discussed before, some businesses are easier to understand than others. With the complex behemoths banks have become, their business models are very difficult to understand. I can't honestly say that they fall within my circle of competence.

But even if one could determine what the assets are worth to some range of values, the amount of leverage used by the banks seriously clouds the value of the equity, which is what you're buying as a shareholder. For example, for Bank A, you may believe the assets are worth $10,000 plus or minus 10%; but if Bank A uses $9000 in debt to fund those assets, the remaining equity value could be anywhere from $0 to $2000. As long as the shares trade in that range, you have no idea if you're buying at a discount to intrinsic value.

Needless to say, the high debt levels used by banks also make them much more susceptible to collapse during downturns, which is a phenomenon we are seeing right now. As we've discussed here, as value investors we much prefer companies with low debt as they have much greater power to weather downturns.

Though many banks have been offering high dividend yields of late, it's extremely important to understand where that dividend is coming from in order to attain reasonable assurance that it is sustainable, as we saw here with WWE. Buying blindly for dividend yield is not an option.

Are there circumstances under which we could buy banks? Certainly. Under a situation where the entire industry is undervalued for example, a purchase of a basket of several banks helps diversify away the risk of failures here and there. This is a similar situation to our approach on pharmaceuticals, where large amounts of research money are being spent, but it's unclear which companies will reap the rewards. Reyer has taken a preliminary look at the attractiveness of the banking sector as a whole here.

The bottom line is, buying individual banks is a risk unless you understand the value of what it is you're buying. Buying because stocks are down, or because momentum is up, or because yields are high does not adequately protect your capital.

Comments

[Dividend Gr...:]

Nicely put Saj. A lot of money has been lost trying to find "the bottom" in financials..

2008 Sep 30 09:36 AM

[helplessobs...:]

The market is full of "good/bad banks". Go with the winner. Panic drove good bank BBT to 18.75. It now trades in the 35 - 40 range almost at its pre panic peak. C is the quintessential bad bank that will come back to haunt the banking industry. Its ills were well known the banking down turn. Adding WB won't improve things much.

2008 Sep 30 10:34 AM

[Dividends A...:]

Agreed....outstanding article. Well written and brings up some points for an investor to reflect upon.

2008 Sep 30 10:47 AM

[investor88:]

Good article with a practical bent of protecting capital. Some wise one said at times like this it about return of capital, not return on capital.

2008 Oct 01 02:24 AM

[fanning:]

Which bank is the leader in providing a steady dividend growth now?

2008 Oct 01 11:14 PM