I'm a picky investor. Having made fewer than 100 investments in my lifetime, I spend a lot more time trying to kill an investment thesis than entertain it.
And much of the time I spend thinking about an investment isn't spent on valuation. In fact, valuation almost always comes last. What I'm most worried about -- and I think what most investors should be worried about -- is whether or not you can even project the economics of a business into the future.
If you can't see where a business is going, can you really own it?
Thinking differently about banks
Bank valuations are all over the place. Small- and mid-cap regional banks are priced at more than 2 times book value. Large, national banks, like Bank of America (NYSE: BAC ) , are priced at tangible book value. Wells Fargo, arguably the "best" large bank, is priced at over 2 times book value.
Then there are the oddballs, companies like BofI Holding (NASDAQ: BOFI ) , which is priced at a monstrous 4 times book value.
Today I want to focus on BofI Holding, since it is the outlier in the banking industry and a company priced so high that it stands well above most banks in existence. (I'll bring back Bank of America in a comparison toward the end of the article.)
BofI Holding is expensive for a reason. For now, it has a competitive advantage in low-cost operations. And it has a very, very good loan book. BofI Holding focuses on writing jumbo loans with low loan-to-value ratios. In the era of Basel III, that's good. Low loan to value ratios and high credit quality allow for more leverage than conventional loans with lower credit quality. That drives higher returns.
It also drives book value protection. If you only loan $300,000 against a $500,000 home, it takes a very serious decline in real estate prices for you to lose money. Arguably, BofI Holding's loan book is much less risky than your average bank.
Turning to valuation
One way to get an immediate return for BofI Holding is to divide return on equity by the company's price to tangible book value. With a rough ROE of 17%-18%, and a price-to-book of 4, BofI returns 4.5% annually to the share price in any given year.
That's the immediate return, though -- the return you get if you measure just one year.
Over long periods of time, the return to the stockholder looks more like returns on equity than it does the returns to the stock.
Suppose, for example, BofI Holding were to generate 17% returns on equity for, say, 20 years. The book value would grow 22 times over during the period. Even if the company were to simply trade at book value at the end of those 20 years, you'd still net a return of about 550%. That's an 8.8% annual return, in line with the typical stock market average. If you waited even longer, perhaps 50 years, your returns on the stock would mirror returns on equity through the period. Similarly, if BofI retains some book value premium, returns would be higher.
But here's the point I want to make with high-flying bank stocks: You have to be willing to hold them for a very, very long time. The only way fundamentals can catch up with valuations is with time. The higher the price, the more time you need to wait for the compounding machine to catch up with the price you pay.
When I look at BofI Holding, I see a bank that has to do very, very well for 20 years to give me a stock market-like return. On the other hand, a bank like Bank of America, which trades right around tangible book value, just has to give me 8.8% returns on tangible equity to mirror the 20-year returns at BofI Holding. And I don't necessarily have to wait 20 years to get that return, nor do I have to rely on a premium price to book value.
Can Bank of America provide 8.8% annual returns to tangible equity over the next 10 years? Can Bank of Internet provide 17% returns on equity for 20 years? If I had to make a wager, a lower return for Bank of America is much more realistic to me than a much higher return for BofI Holding.
The Foolish bottom line
It can make sense to pay up for quality. BofI Holding is a quality bank with a quality loan book. But it's based on a new business model in what is, by all definitions, a commodity industry. So projecting the competitive pressures two decades from now is, in my view, a very difficult thing to do.
When you think about bank stocks, think for the long haul that you are comfortable projecting. For me, I find it much easier to project that Bank of America generates an 8.8% return on equity for a short period of time (and probably forever) than BofI Holding returning twice as much to equity for 20 years.
Remember, there is no reward for making investing difficult. Often, the most simple observations create the biggest stock market winners.
A bank to buy and hold forever
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