Guide Suhail Chandy And Weison Ding
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“Finally,thesingular,comprehensivemanuscriptforbankinvestingI wishI’dhadatthebeginningofmycareer.SuhailandWeisonclearly chronicletheevolutionandcurrentchallengesoftheindustryforthe amateurenthusiast,whilesimultaneouslysupplyingthetechnical depth,practicalexecution,andoperationalguidanceforinstitutional investors,sell-sideanalysts,andexecutivemanagementteams.”
—TylerStafford,CFA, CEOandCo-Founder, PanaceaFinancial;FormerSell-SideBankAnalyst
“BankInvesting:APractitioner’sFieldGuide explainsanddetailsall ofthecriticalvariablesinvestorsneedtoanalyzeinordertomakethe rightdecisionsinbankstockinvesting.ChandyandDinglayoutboth themacroandmicrofactorsneededtoaccuratelydeterminethefair valueofabankstock.Thisbookwillquicklybecomethego-tobookfor bothneophyteandexperiencedbankstocksinvestors.”
—GerardS.Cassidy, ManagingDirector,HeadofBankEquity Strategy,andLargeCapBankAnalyst,RBCCapitalMarkets andcreatoroftheTexasRatio
“SuhailandWeisonhavewrittenatrulycomprehensiveguidetoinvestinginbanks.Theirapproachprovidesacomprehensiveframeworkfor analyzingthemostcriticalandoftenmostchallengingtopics,includingabank’sinterestratesensitivity,creditexposure,andliquidityand capitalposition,andprovidesvaluablecasestudiesandinsightsfrom professionalinvestorsinthisspace.Thisbookisamust-readforevery bankinvestor,fromthenovicetothemostseasoned.”
—EricWasserstrom, EquityAnalyst;FormerHedge FundPortfolioManager
“SuhailandWeisonhavecollaboratedonamust-readthatwill proveinvaluabletoallconstituentsofthebankandbroaderfinancial servicessector.Thecommentaryisinsightful,educational,entertaining, andinformative,helpingthereadertounderstandthehistoryofthe sector,itsfundamentalunderpinnings,andthetransformationand convergencewithfintechthatiscurrentlyunderway.”
—JoeFenech, CIO,GenOppCapitalManagement; formersell-sidebankanalyst
CHAPTER 1 Introduction
“Thejudiciousoperationsofbankingenablehimtoconvertthisdeadstockinto activeandproductivestock;intomaterialstoworkupon,intotoolstoworkwith,and intoprovisionandsubsistencetoworkfor;intostockwhichproducessomething bothtohimselfandtohiscountry.”
–TheWealthofNationsBookII:OftheNature,Accumulation,and EmploymentofStock, AdamSmith
WHYABOOKONBANKINVESTING?
Webelievethatbankinvestingcanbeafruitfulpursuit.Asauthorsofabook onthetopicwehaveavestedinterest,butweaskthereadertoconsiderthe following:
1. Themostsuccessfulinvestorofourtimes,WarrenBuffett,hashadasizeableinvestmentinbanksovertime(closetoathirdofhisportfolioweight usedtobeinbanks).Thisisbasedontheminorityinvestmentsinpublicly listedentities,andwedonotincludeBerkshire’soperatingsubsidiaries.
2. Banksallowyoutomakemacroeconomicbetssincetheyarehighlyleveredtobusinesscycles.
3. Bankinvestingallowsyoutoscaleyourknowledge,astheyhaverelatively homogenizedbusinessmodels.
4. Atthesametime,banksarediverseenoughtodrivemeaningfuldispersioninpriceperformance.Thisdivergenceofperformancecanbetaken advantageofbyanastuteandpreparedsecurityanalyst.
5. Banksaregreatvehiclestomakespecificinvestmentplaysongeographic regions,demographictrends(suburbantourbanmigration,aging),industries(agriculture,tech,energy),newsflow(trade/tariffs,weather),real estatesubsectors(NYCoffice,bayareaapartments),andinvestingthemes suchasESG,cryptocurrency,andventurecapital.
6. Thelargestassetonabank’sbalancesheetisitsloanbook.Thisisnot directlyanalyzable;onecannotwalkuptoabankandaskpermission
toviewtheloanbook.Therearelimitedinstanceswhenasmallbankis gettingre-capitalizedthatitsloanbookmaybemadeavailableinaselectivesamplemanner,butthoseareverylimitedinstances.
Thisinformationasymmetrymakesittougherbutalsoinsome instancesrewardsthediligentanddoggedanalyst.Thisrelativeopacity makesbanksverydifferentfromanalliedsectorsuchasREITs.Thereal estateassetsofaREITaretangibleandcanbetouredandindependently assessed.ThereisalargeCREmarketwhererealestateassetstrade,and onecanusethattovaluetheassetsofREITs.Wehighlyrecommend anexcellentbookonthetopicofREITsbyourgoodfriendStephanie Krewson-Kellyandherco-authorR.BradThomas.Thatbookis The IntelligentREITInvestor:HowtoBuildWealthwithRealEstateInvestment.
7. Fintechdisruptionisreal,buttounderstandthisphenomenononeneeds tounderstandthesectorbeingdisrupted.Itisnotacoincidencethat someofthebiggestfintechnameshaveappliedforandobtainedabank charter.Thatisavalidationthatachartercanprovidebenefitsexceeding theregulatorycost.Finally,webelievethatfintechdisruptioniscreating aninvestingopportunitytoplaythedigitaldividebetweenbanksthat embracetechnologysuccessfullyandthosethatgetleftbehind.Banks havetostartviewingthemselvesasfintechswiththeabilitytoaccept deposits.
FINTECHONSLAUGHT
Thefintechonslaughtisjustgettingstarted.Thereisnodenyingthatfintechis disruptingthebankingbusiness.Thechallengersand“potential”challengers rangeinsizefromminnowsbeingdreamtupindormroomstogiantssuch asAmazon.AstudybytheconsultingfirmBainandCompanyin2018postulatedthatAmazon’sbankingservices,iflaunched,couldgrowtomorethan70 millionUSconsumerrelationshipsoverafive-yearperiod.Seethelinkbelow: https://www.bain.com/insights/bankings-amazon-moment/ ThiswouldbethesamesizeasWellsFargo,foundedin1852,whichisthe fourthlargestbankinthecountry.WearenotprivytotheplansofAmazon, butwearenotsurprisedbythehypotheticalgrowthtrajectoryofapotential challengerwhohassignificantheftandhasconsumedentireindustries.While notsurprising,itisunsettlingthatsomeonetakes168yearstobecomethe fourthlargestbankandthenfindthemselvesrivaledbyadigitalupstartwho tookfiveyearstogettothesamesize.
Therelentlessfintechonslaughthasseenskyrocketingvaluation,aburgeoningnumberofplayers,increasinginterestintheconcept,andabarrage ofnewsflowallreinforcingeachother.
EXHIBIT1.1
Source:GoogleTrends
Fintechunicorns,ofwhichthereare58,haveanaggregatevaluationof $213.5BaccordingtoCBInsights.Nearlyeverytransactiononewouldtraditionallydowithabankcannowbedonethroughafintechusingamobileapp onyoursmartphone.ThefintechsincludeSoFi,Earnest(ownedbyNavient), Chime,Varo,MoneyLion,Stash,Square,Kabbage,OnDeck,Affirm,Klarna, Greensky,Afterpay,andalonglistofvendorscoveringresidentialmortgage loans,studentloans,onlinecheckingandsavings,SMBloans,point-of-sale financing,andmore.Thelistisendless,andthereisavirtualtapestryoffintechlogosthatcoveravarietyofareas.
InterestinfintechhasgrownimmenselyascanbeseeninExhibit1.1,a chartofGoogletrendsonthesearchterm fintech overthelast10years.
ANOPPORTUNITYTOLEVELTHEPLAYINGFIELD
Whileinnovationisexciting,itisimportanttonotgetcaughtupinthefintech narrativeandlosesightthatultimatelybankingatitscoreisaboutaccepting deposits,makingloansprofitably,acquiringcustomersefficiently,andengagingwithcustomersmeaningfullytoincreasethecross-sellofproducts.Itis alsoimportanttorememberthatseveralnewagefintechlendershavenotbeen fullycycletested.
Branchlessbanksarenotanewconcept.Telebank,adivisionofTeleBancFinancialofArlington,VA,wasfoundedin1990andoperatedwitha branchlessstrategyinitiallyusingthetelephonenetwork.SecurityFirstNetworkBank(SFNB),foundedin1995,wasapureinternetbank.
Whilebranchlessbankingisatleast30yearsold,thenewageofthechallengerbanksisfueledbypowerfulsmartphones,amobileappecosystem,and abunchofcriticaltechnologiesandAPIsthatallowtheorchestrationofbank transactionsandactivitiesinaseamlessmanner.
Banks,especiallyregionalandcommunitybanks,havealottoworry aboutgiventhisrelentlessonslaughtfromnimblestart-upsandthelevelof techspendingatthelargebanks.Thelargestsevenbanksinthecountryare collectivelyspendingupwardsof$45Bontechnology.Smallerbankswillnot beabletomatchthatlevelofspending.However,inthisDavidversusGoliath struggle,allisnotlostforDavid.
Itisaccurateandintuitivethatsmallerbankssimplydonothave theresources(bothtalentandbudget)tocompetewiththelargebanks. However,iftheypartnerwiththerighttechnologyvendors,forefficient digitalacquisitionofcustomers,frictionlessservicesprovidedviamobileand online,andreassuringlevelsofcybersecurity,Davidwillmorethanmatch Goliath.
Inordertocompetesuccessfullybanks,largeandsmall,havetoreimagine themselvesasafintechwithabankcharter.
Whiletheycan’tmatchthelargebanksinspendingbillionsontechnology ayear,thereisnoonestoppingsmallbanksfromarchitectingavisionfortheir digitaljourneyandpropellingthisjourneybyembracingtherightsetoftechnologies.Asanecdoteswecanthinkofnumerousexamplesofsmallerbanks acrossthecountrythathaveembracedtechnologyappropriatelyandhaveseen greatsuccesswiththerampofcustomersusingmobileandsignificantlybetter customerservicescores.
Thechallengetoembarkingonasuccessfuldigitaljourneyisinpartculturalandinsomewayslimitedbyimagination.Alicensetoacceptdeposits andsubmitoneselftoregulatorysupervisiondoesnotimplythatbanksneed tohandcuffthemselvestothepast.Itistimeforsmallbankstounshackle themselvesandembracetheirdigitalfuture.
Whilethedigitalfutureisexciting,wehavetoacceptthatthebankmodel isadouble-edgedswordwhenitcomestoregulation:ontheonehandit affordsprotectionandtheabilitytoacceptdeposits,butontheotherhandthe burdencanbeonerousforsmallbanks.Thus,ontheonehand,wehaveseen fintechsthathaveshowninterestinseekingbankcharters,whichvalidates theviewthatthebankmodelisasourceofstrengthalbeitonethatneedsto bereinvigoratedwithnewtechnology.Ontheotherhand,therearefintechs thatdonotwishtoseekabankcharterinpartduetotheirviewthatthe regulatoryburdenisnotworththeirwhile;whererequired,thesefintechs partnerwithbankswhitelabelingtheproduct.Theincreasingregulatory burdenisonereasonwebelievethatthenumberofde-novoapplicationshas beenwellbelowpre-GlobalFinancialCrisis(GFC)levels(Exhibit1.2).
Source:S&PGlobalMarketIntelligence Note:asof6/9/2019
WeareveryencouragedbythestepstakenbyFDICChairJelena McWilliamstoencouragenewbankformation.Herearecommentsshemade inthe2018FDICAnnualReport.
“OneofmytopprioritiesasFDICChairmanistoencourage moredenovoformation,andwearehardatworktomakethisa reality.. .
Denovobanksareakeysourceofnewcapital,talent,ideas,and waystoservecustomers,andtheFDICwilldoitsparttosupportthis segmentoftheindustry.”
“TheFDICalsotookrobuststepsthisyeartoreducetheregulatoryburdenoncommunitybanks,withoutsacrificingsafetyandsoundnessorconsumerprotections.Weeliminatedoverone-halfofthemore than800piecesofsupervisoryguidanceoutstanding.Wealsolaunched apilotprogramtousetechnologytoreducethenumberofon-sitedays neededtoconductanexamination,andtookotherstepstoreducethe costsofexaminationstoourregulatedinstitutions.”
–MessagefromtheChairman,FDIC2018AnnualReport
FINTECHTRAILBLAZERS
Wewillbeinterviewingafewmanagementteamsofbanksthathaveboth successfullyadoptedtechnologyaswellasafintechCEOwhoisakeysupplier tothefintecharmsracebetweenbanks.
PASTISPROLOGUE:THEULTIMATEFINANCIALINNOVATION
Itisagiventhatbankstodayareadeeplyintegratedcornerstoneinmodern economies.Andwhenwesay“banks,”whatwereallymeanisthefractional reservebankingsystem.Thatis,thepoolingtogetherofdepositsandthesubsequentlendingoutofmostofthosedeposits.Withoutthissystem,vastsums ofwealthwouldbestuck“dead”invaults,generatingzeroeconomicvalue andmassivelyincreasingfrictionwithintheeconomy.Indeed,aworldwithout banksisahardonetoimagine,butmodernbankingwasnotalwaysaround.
ThestorygoesthatEuropeangoldsmithsintheseventeenthcentury servedas“depositories”forpreciousmetals,chargingcustomersasmall feetostoretheirwealthwithintheirvaults.Thegoldsmithswouldissue redeemablereceipts,whichwouldrepresenttheirphysicalholdings.Atthe time,feeswereanecessity.Security,bookkeeping,andotherexpensesto maintainavaultwereallcostly.Evenso,customerswerewillingtopaythis fee,asthealternativeofprotectingyourownwealthwasevenmoreexpensive andfrankly,risky.
Soonthesegoldsmithsrealizedthevastmajorityofwealthwithinthe wallsoftheirvaultswascollectingdust,andsotheybegantolendoutand earninterestonaportionofthesedeposits.Aportionofmoneywaskeptas “reserves”toservicepotentialwithdrawals.Theseloaned-outmonieswould bespentorinvested,makingtheirwaythroughtheeconomyandeventually endingupasanotherdepositinanothervault,readytobelentoutagain, creatingavirtuousmultiplier.Thus,fractionalreservebankingwasborn.
Thoughitseemsstraightforward,atthetimethismusthavebeena groundbreakinginnovation.Imaginebeingadepositorycustomeratoneof thesegoldsmiths,andsuddenlybeingofferedinteresttohavethemprotect andbookkeepyourwealth!
Furtherdevelopments,suchasthepermanentissuanceofbanknotes,centralbanking,andtheeventualdecouplingofacurrencytoanunderlyingcommodity(i.e.,thetransitionfromthegoldstandardtofiat),soonfollowed.But thefundamentalnutsandboltsofgatheringandlendingdepositsremainin placetoday.
THEHEREANDNOW
Today,thepoolingofdepositstocreatecreditisfoundationaltotheefficient allocationofresourcesfromthosethathave(depositors)tothosethatneed (borrowers),andisanimportantmechanismfortheapplicationofmonetary policy.
IntheUnitedStates,bankshaveaccumulatedover$13trillionindeposits, andthankstothefractional-reservebankingsystem,ahugechunkofthese depositshasbeenproductivelylentoutintoeverycorneroftheeconomy.
Banksarecertainlynottheonlyfinancialintermediaryintownthough. TheFederalReserve’sZ.1Tablesshowusthatalthoughbankshaveaplurality ofthetotalloanmarket,banksonlyholdaboutathirdofthe$27trillionintotal loansthatexistintheeconomy(Exhibit1.3).BankscontendwithGovernment SponsoredEntities(likeFannieMaeandFreddieMac)andotherprivateinstitutionslikeasset-backedsecuritiesissuersandfinancecompanies.Outofall ofthese,creditunionsareperhapsthemostsimilarinformandfunction.
Banksalsohaveameaningfulphysicalpresenceandareubiquitously wovenintothebuiltenvironmentaroundusthroughextensiveATMand branchnetworks.Despitetheseemingpervasivenessofbanks,Americaas awholeremainsunderbanked.TheFederalDepositInsuranceCorporation (FDIC)recentlyreportedthat19%ofhouseholdsintheUnitedStates(a whopping24millionhouseholds)were“underbanked,”whileanadditional 8.5millionhouseholdswereunbankedaltogether(2017FDICNational SurveyofUnbankedandUnderbankedHouseholds).Werecommend The
EXHIBIT1.3
UnbankingofAmerica byLisaServonformoreonthistopic.Thatsaid,the remainingpopulationisoverbankedtoadegree.AccordingtotheWorld Bank,commercialbankbranchesper100,000adultssitinthethirtiesforthe UnitedStates,ascomparedtomid-twentiesforotherhigh-incomecountries. InacitylikeDallas,thereare74differentbankswith370branchesbetween themcompetingforcustomers.Onlythreeofthesebankshaveadeposit marketsharegreaterthan5%.
ThemapinExhibit1.4showsallUSbankbranches(exceptHawaiiand Alaska)aswellasstatelevelpopulationdensity,illustratingthenon-uniform distributionofbranches.
Thebankingindustryhasbeengoingthrougharemarkablysteady periodofconsolidation,evendespiteeconomiccycles.Thetotalnumberof FDIC-insureddepositoriespeakedin1985at18,000,andnowsitsbelow6,000 (Exhibit1.5).
Shiftingtoapublicsecuritiesmarketperspective,banksmakeupameaningfulproportionofaggregatemarketvalue.Forinstance,ifwelookatthe S&P500,financialsareabout10%oftheindex.Withinfinancials,banksare thelargest subsector at$3.0trillion,andincredibly,haveamarketvalueequal tothatofsome entire industriesintheS&P500suchasenergyandindustrials: https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/ sectors_in_market.jhtml
CommunityBanks areatypeofbankthatfocusesonbankinglocalcommunities,derivingthemajorityoftheirincomefromspreadincome,thatis arbitragingthespreadbetweeninterestpaidongathereddepositsandinterestearnedonloans.Communitybanksaredeeplyembeddedwithintheir localcommunities,andasaresulttheyhaveanintegralunderstandingofthe communitiestheyoperatewithin.Thislocalexpertiseisirreplaceablewhen itcomestoefficientreallocationofcapital.WhereastheJ.P.Morgansofthe worldhavethesizeandscaletobankmultinationalcorporations,community bankshavetheabilitytodevotetheirresourcesinabespokewayfortheirlocal communities.
Theterm communitybanks hasneverhadastrictdefinition,thoughoften timesanassetcapisusedasaproxy.Mostputthisassetcapinthe$10billion range,whichwefindreasonable.However,wewillresistcommittingtoahard number,asinflationandtheregulatoryenvironmentmakethissomewhatof amovingtarget.
EXHIBIT1.5 NumberofBanks
20,000 1986Q1: 18,083
2019Q2: 5,303
Source:FDIC
WHYINVESTINCOMMUNITYBANKS?
Forstarters,therearealotofthemtochoosefrom.Nearly800publiclytraded bankshaveassetsbelow$10billion,givinganypotentialinvestorahugepool ofinvestablesecurities.Further,onceyou’vefamiliarizedyourselfwiththe peculiaritiesoftheindustry,yourknowledgewillbemostlyapplicabletothis ratherhomogeneousbusinessmodel.
That’snottosaythatreturns within thebankspacearehomogenized though.Thereisenoughspecializationwithintheindustry,whetheritbegeographicallyorinlendinganddepositgatheringstrategies,thatperformance canvarywildlybetweenbanks.Forinstance,abusinessbankbasedinTexas wouldbenefitmorefromrisingoilpricesandarisingFedFundsrate,thana mortgagebankbasedintheNortheast.
Consolidationisalsoaseculartailwindthatbenefitsbankinvestorsas well.Forinstance,in2017therewereatotalof305dealsannounced,and80 ofthetargetswerepubliclytraded,implyingnearly1in10publiclytraded banksweretakenoutinjustoneyear.
Inthisbook,youwillgetinsightsfrominterviewsconductedwithreal industryleaders,fromthosethatoperatebanks,andthosethatinvestinbank stocksandinthecreditmarkets.Further,wewillprovidetherequisiteinformationthatanyinvestorwouldwanttoknow,includingtheidiosyncrasiesin financialstatementanalysis,capitalandcredit,theregulatoryenvironment,
andvaluation.Ultimately,wehopetoleaveyouwithallthetoolsnecessaryto besuccessfulininvestinginbankstocks.
Thisbookgivesyoutheessentialtoolkittobecomeasuccessfulbank investor.Itpackagespracticallessons,theoreticalknowledge,andhistorical context,allintoonecompellingandentertainingbook.Thisisabasic101on investinginbanks,asthereisalotofmaterialthathasbeenleftonthecutting roomfloor.Wearesuretohavemadesomeerrorsaswell.Weinvitereadersto sendallcommentstobankinvesting101@gmail.com.
