Any well diversified portfolio needs to have a big financial company in its holdings. With all the uncertainty in the financial sector the past few years, investors may be leery of wading into the waters without some guidance. One way to pick a strong financial company for your portfolio is to use what regulators use to grade banks. Regulators use CAMEL ratings to monitor banks. CAMEL stands for: Capital Adequecy, Asset Quality, Management, Earnings, and Liquidity. This rating is usually kept secret and details about the ratings are rarely made public. But investors can still use this concept to make solid investment decisions in their portfolio and here's how:
Capital Adequacy and Asset Quality
Banks are built upon the concept of transferring money from savers to investors, think individuals and businesses, which can use the money more effectively. In other words, the bank uses the money in its deposits to fund loans that are supposed to return a higher interest rate than the interest the bank is paying those who have deposits with them. The spread between the interest received from loans and the interest paid to depositors is the main source of revenue for a bank.
Not all loans work out. This was painfully obvious in 2007 and 2008 during the financial crisis. Banks need to have sufficient capital in order to handle bad loans and changes to the economy. This also means that the quality of those assets is important as well. For example, the lower the down payment on a house, the more risk is being carried by the bank. So how can investors measure capital? There are many methods but the most conservative is the Tangible Common Equity Ratio.
Tangible Common Equity Ratio takes Total Equity minus Goodwill and Preferred Stock Equity and divides that by Total Assets minus Goodwill and other Intangible Assets. The thought process behind the ratio is: how much capital is behind the loans in the bank's portfolio. The higher the ratio, the less capital is at risk for their loan portfolio.
Banks with high Tangible Common Equity Ratios:
Wells Fargo (NYSE:WFC) 9.67%
Capital One (NYSE:COF) 9.57%
Banks must walk a fine line between putting their assets to work and becoming over leveraged. This is where management's performance is so important. A good manager can mitigate risk and give shareholders a good return on their investment. The best and easiest way to gauge management is to use Return on Assets or ROA.
Return on Assets measures how much value management has been able to create with each asset. This is important for banks because if their assets, loans, are not bringing any return to the bank, investors may see a bank's balance sheet deteriorate quite quickly. So the question that has to be answered is: Is management using the deposits on hand to invest in assets that are making them money.
Banks with high Return on Assets:
Wells Fargo 1.52%
Earnings are a big deal for any company and banks are no different. Are they profitable? This goes back again to management, are they operating the bank wisely and growing the business. Now a bank may not be able to give you the same sky high earnings that a young tech company would but they can still grow at a good rate.
To measure this, investors should be looking at how earnings have played out in the past and see if they are on an upward trajectory. Also, investors should pay attention to earnings reports and pay attention to increasing revenues, stronger spreads, and the banks growth rate.
Banks with good quarterly earnings growth yoy:
Bank of America (NYSE:BAC) 62.9%
Citigroup (NYSE:C) 42%
Banks need to be able pay their depositors. The big concern during a financial crisis is a run on the banks. This is where panicked customers try and withdraw all their money at once. This can lead banks to have to sell assets quickly and at prices below normal market value. When the bank cannot cover the deposits (liabilities), it becomes insolvent.
To avoid having your investment wiped out, you should look for bank that have enough liquidity to handle emergencies. A good way to measure this is by taking all the banks outstanding loans and dividing them by total assets. If the number you get is greater than 65%, the bank is illiquid. This may be one of the most important measures during unsure economic times.
With new BASEL II standards, most major U.S. banks have strong liquidity. When comparing banks based overseas, looking at liquidity is vital. This is especially true in emerging markets. Emerging markets tend to have looser financial regulatory standards. This can lead to financial crises that appear to come out of nowhere. But if an investor keeps an eye on the liquidity of that markets banks, they are less likely to be caught by surprise.
CAMEL is a great way for investors to pick and monitor their investments in financial institutions. It can give an investor a heads up to what regulators are looking at. Bad overall CAMEL ratings can mean a bad investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.