Mail Bag: Investing in Bank Stocks

A comment reply I needed to post about the Wachovia banking collapse was too large to fit in the comment thread so I am publishing it as a mail bag feature.

Joshua, this has been one of my favorite posts that you’ve ever written, and that’s saying something!

Here’s a question I’ve had about bank investing in general, and I was wondering if you could shed any light on it: What’s the clearest way to tell the difference between investing in something like Wells Fargo, compared to say, Wachovia, during a banking crisis? Obviously, if someone sunk $10,000 (or whatever) into Wells Fargo during the height of the panic, he would have been making a once-in-a-lifetime kind of investment. Likewise, if he had bought Wachovia, he would have been entering go-back-to-go territory. I’ve noticed that the investors I admire tend to gravitate towards Wells Fargo and US Bancorp and away from, say, Citigroup, but I was wondering if you had anything to say that would perhaps lead an investor to buy shares of Wells Fargo instead of Wachovia during a severe financial crisis. I’m curious as to how you successfully made this determination in the heat of the moment.

Fratman

Banks, in general, make me nervous.  It is a lot easier for a fool to get in charge of a bank and wipe out a century of work.  A good bank cannot take a lot of abuse, unlike, say, a good packaged foods company.  I will always be keen on picking up ownership in a cheap, well run bank, but I would not want a majority of my net worth in one absent some fairly extraordinary circumstances.  Even then, I’d likely be trying to find a way to diversify the risk.

This is a little bit unfair because over a long period of time, a good bank should return its purchase price to the owner, plus some, almost by definition even if it were to be wiped out in the end.  Consider the story of Marianne Cosgrove:

Marianne Cosgrove’s family has been socking away stock of National City Bank since the 1880s.

Fifteen years ago, the 96-year-old great-grandmother in Atlanta inherited 3,620 shares from her sister, Betty Lawrence, a former fashion illustrator at the old Shillito’s department store in Cincinnati, who made her promise never to sell it.

The first shares of the prized investment were originally purchased by the Cincinnati family of Betty’s long-deceased husband, Shirley Lawrence. Subsequent owners added to the stake. Every family member who owned the stock made their heirs pledge to keep it.

The retired federal worker kept the vow she made to her sister as she watched the stock’s value plunge from more than $100,000 to about $6,300. The healthy quarterly dividend that she once relied on to make ends meet has dwindled to a pittance.

Shares bought since the 1880s – somewhere between 120 and 130 years ago – have certainly given the family far, far, far more in cash dividends than the original cost.  Even with the wipe-out they experienced, the investment made them much more money than they ever would have had otherwise so it’s difficult to consider it a failure in the scheme of things, despite it ending in a painful way.  After all, if your great-grandparents planted a fruit tree, and your family harvested, and enjoyed, fruit from that tree for several generations, weren’t you still better off even if the tree were destroyed in a storm?  Your job is to not rely on a single fruit tree but, rather, to build your orchard.  Preferably several orchards that are geographically diversified, always keeping an eye on correlated risk.

When you have something that produces good amounts of cash for your family, generation after generation, that truth isn’t negated because a disaster occurs that destroys the goose laying golden eggs.  It just means there will be no more future golden eggs.  That’s cold comfort now but it is an economic truism.  The loss of future utility doesn’t mean a retroactive dispersion of past utility.

These two forces – banks using lots of leverage coupled with the human tendency to want to reach for a little extra yield – have caused me to only own two major national banks in my lifetime on any meaningful scale, both of which were bought nearly a decade ago, with additional positions acquired in the subsequent years.  The first was U.S. Bancorp, the second was Wells Fargo & Company.

I had always been open to buying shares of a few other banks, as well, such as Northern Trust, but it never happened because there was something more attractive at the time.  Were I to find a high quality bank at a low price, I’d probably buy into it.  I don’t mean to sound like I’m against bank stocks as a class – I’m not.  I love collecting the dividends on my U.S. Bancorp and Wells Fargo shares.  They funded, in part, my purchase of other securities when the world was falling apart and they were trading at 1/3 our estimate of intrinsic value.

What I Looked for When Selecting My Bank Investments

There were reasons that I selected those two firms as my bank exposure:

• They had different geographic footprints.  People seem to forget it but a bank is, to some extent, subject to the same risks an insurance or reinsurance company faces.  Imagine you owned a community bank in Joplin, Missouri before the tornado struck and wiped out the town.  If only a small number of homeowners were able to recover, it might be enough to shove your bank into insolvency due to the leveraged nature of the industry.  Thus, geographic diversity is good.  An earthquake that made California fall into the sea would hit Wells Fargo harder than U.S. Bancorp.

• Both banks had good returns on assets without using a lot of leverage, augmenting the return by using fee income as a profit enhancer to the traditional business of generating profit from interest spreads.  They are, in a sense, not just banks.  They are credit card companies, mutual fund management businesses, and, in some cases, underwriting investment banks.

• The CEOs both owned very large outright share positions in the business.  This meant they were collecting hundreds of thousands of dollars a month in the same plain vanilla dividends that the regular stockholders collected.  That is a powerful incentive to protect the business, and thus the dividend in the long-run, even if means shutting the dividend off temporarily to build equity.

• The loan books were fairly simple, straight forward, and easy to understand.  I could see the overall capital at risk in certain areas – office buildings, residential, etc. – in certain areas of the nation.

• The management teams had a history of ample reserves to offset credit losses.

• The dividend yields at the time, as well as the price-to-earnings ratios relative to growth, were attractive.

• There was not a lot of subprime exposure on the books of the businesses.  Even if it hadn’t yet showed up in the figures, it did not take a brain surgeon to figure out that a lot of relatively poor people using a lot of relatively large leverage was not going to end well.

• It didn’t look like there were a lot of games going on with the loss developments and reserve figures.

I looked at Wachovia back in 2005 and ended up going with U.S. Bancorp, instead.  The numbers just seemed – cleaner.  There was no pretense with U.S. Bancorp.  They weren’t trying to do anything crazy.  They weren’t talking about all of the exciting opportunities out there and a desire to rapidly expand the real estate loan portfolio.  They simply said: If we can make money on a risk-adjusted basis, we’ll underwrite loans.  We’ll do the best we can but you’ll have to live with the results.  That may mean we aren’t the fastest growing in the industry, but we’ll try to make up for it by getting into things like credit card processing.

That appealed to me as someone who studied the tendency of banks to do stupid things with other people’s money.

On the same note, even though there have been periods of large out-performance for shareholders, historically, I have avoided Citibank like the plague.  My entire adult life, it has been a monstrously large, overly-complex, mess.  It always needs to be restructured.  It always has turnover in certain jobs.  It is not made up of many people who worked their entire life up the bank and have most of their net worth tied to the dividend income from the bank.

After hours of going through Citigroup’s SEC disclosures, and then cross checking those with the FDIC information to try to get a better handle on the books, I think it’s too complex to manage.  It’s a case of an empire spread so large, and so wide, and so disjointed, that it doesn’t work.  The idea would be great – imagine a bank where you could log-in to monitor your insurance, stocks, asset custody, checking, savings, et cetera – but they never used technology to create an all-encompassing portal to achieve that.  The promise of the model was that a college student could walk into a branch with $1,000 and say, “I want to add some shares of Coca-Cola to my account”.  But that reality never came to fruition.  That could change in the future, of course.  Maybe there exists a day when I wake up and Citigroup is attractive, causing me to buy it.  That day is not today.

In short, I feel like I have a decent handle on the risks of owning a stake in U.S. Bancorp or Wells Fargo.  I don’t feel like I can tell you the risks of owning Citigroup.  I have no idea what is lurking in the numbers – good or bad.  Again, that might change.  The banking crisis looks like it shook up the business, and I haven’t looked at it for a couple of years.

Long story short, if I am buying a bank, here is how I approach it:

How would I feel if I woke up tomorrow with 100% of my net worth invested in this bank?  I can’t buy or sell a single share for 10 years.  I have no control over management.  Am I going to lose sleep if the economy goes off a cliff?  Banks are highly leveraged; what are the chance of a needed equity infusion wiping out my proportional ownership stake in the firm so that even if it does recover, I never do?

Citigroup never passed those tests.  It doesn’t mean it is a bad business, it just means it is off my list.  Someone else may understand it much better and may make a lot of money owning it. Or they may not.  I have no idea.  It isn’t necessary for me to have an opinion on the matter to do well, and grow wealthier, over time.  I don’t have to swing my proverbial bat at that ball.  I’ll leave it for someone else.

As for the executive compensation question, I look at something like U.S. Bancorp and see that Richard Davis is making $18 million.  I have no problem with that because during the worst banking crisis in a generation, his bank not only did not want to take TARP but was required to by the government, after-tax profits were $4,721,000,000.  Giving him $18,000,000 for protecting the other stockholders, or 0.38% of the bank’s net profits, seems reasonable.  Some of the other executives in the industry got greedy and bankrupted the stockholders in the process.  He protected the bank, grew its footprint, and did it by sticking to what works: Keeping costs low, insisting on credit-worthy borrowers, and returning most of the profit each year to owners in the form of a dividend.  I like that we pay him well.  I want to keep him in the executive suite, happy, as long as we can.

That said, remember my relative who has been building a significant collection of U.S. Bancorp shares through the direct stock purchase plan?  The other day, this person was over visiting.  As a result of the banking crash, and the subsequent recovery, the account has become significant.  The dividend income is now reaching into the thousands of dollars a year, and he keeps buying.  Only, now, the monthly contribution has grown to $500 or so.  It’s gotten to the point that even though I, personally, have considered buying some additional shares of U.S. Bancorp for one of my own retirement accounts, I told him he should probably consider splitting the fund into something else.  There is no downside to getting the same growth profile and dividend income from something like General Mills or Johnson & Johnson instead.  (I’m not recommending either of those businesses, just naming two large, well-known, long-established stocks that would be classified as “blue chip” on Wall Street.)

Once the bank holdings creep past a certain point, there’s just this little nagging sense in the back of my mind, reminding me of history.  This story repeats itself going back thousands of years.  It’s a personal thing.

Note: This does not indicate that I think bank stocks are overvalued right now.  There are some that are very cheap and that I will probably purchase at least a few of these banks for my household portfolios in the coming months.  This response is designed to answer you about how I view the industry, in total, over very long periods of time, in the context of a complete portfolio.

Update: Let me be very clear about this post and provide some historical context.  Several years ago, I placed this response, along with thousands of other posts, in the private archives.  The site had grown beyond the family and friends for whom it was originally intended into a thriving, niche community of like-minded people who were interested in a wide range of topics, including investing and mental models.  I decided, after multiple requests, to release selected posts from those private archives if they had some sort of educational, academic, and/or entertainment value.  This special project, which you can follow from this page, has been interesting as I revisited my thought processes about a given company or industry, sometimes decades later.  This particular post was one of the ones that was specifically requested.  I am restoring it as an accommodation.  For me to be comfortable doing that, I made some non-material updates to clean up the text, add clarity, and improve the image resolution and format layout so it fits with the new blog template.  The post was released from the private archive 05/26/2019.  It does not represent my thinking as of that date.  It represents my thinking as of its original publication date, 02/03/2013.

One major change that has occurred in the six years since this post was originally published: my husband, Aaron, and I relocated to Newport Beach, California in order to have children through gestational surrogacy.  Within a window of a couple of years around that relocation, we also sold our operating businesses and launched a fiduciary global asset management firm called Kennon-Green & Co.®, through which we manage money for other wealthy individuals and families.  That means we are now financial advisors (or, rather asset managers operating under a investment advisory model as we are the ones making the capital allocation decisions rather than outsourcing those to fund managers or third-parties), which was not the case at the time this was written.  Accordingly, let me reiterate something that should be perfectly clear: this post was not intended to be, and should not be construed as, investment advice.  It was a broad, philosophical and academic discussion about my personal feelings on acceptable risk parameters when considering exposure to highly-leveraged financial institutions.  I explained why my family had behaved in certain ways, and acquired certain assets, during and in the aftermath of the Great Recession.

For the sake of full disclosure, I’ll state outright that Aaron and I, and/or some of the clients of our asset management firm, may own, buy, sell, or otherwise engage in transactions involving shares of any bank at any time, including, but not limited to, Wells Fargo & Company, U.S. Bancorp, and Citigroup.  For example, personally, as of this morning, Aaron and I still hold a significant stake in Wells Fargo & Company through our family portfolio as the bank has treated us very well over the years, especially relative to the prices we paid for it.  I express no opinion about whether or not it will generate a profit – it may not because it, like any business can go bankrupt – and am providing access to this old post solely as a courtesy due to the request that I restore it.  We may wake up tomorrow and sell our shares of Wells Fargo & Co.  Or we may not.  Or we may buy more.  This goes for any other bank or financial institution (or any other stock or security for that matter).  You should talk to your own qualified, professional advisors about what is right for your unique circumstances, goals, objectives, and risk tolerance.  I cannot, and will never, offer investment advice on this, my personal blog.