Industry Focus: Adaptation and Financial Companies

The taxi industry is in a world of hurt. With Uber and other upstart companies siphoning off passengers, the evidence is mounting that the value of taxi medallions, which give drivers the right to operate a taxi, is dropping precipitously in cities like Chicago and New York. In this week's edition of Industry Focus: Financials, Motley Fool analyst Gaby Lapera and senior banking specialist John Maxfield talk about a company at the center of this storm: Medallion Financial (MFIN -3.14%).

Moving from one niche financial company to another, Lapera and Maxfield then turn their focus to SVB Financial Group (SIVB.Q), the parent company to Silicon Valley Bank, a regional bank based in, you guessed it, the Silicon Valley that caters to young companies in the technology industry. Listen in to the video below to learn what makes this bank so unique.

A full transcript follows the video.

This podcast was recorded on Dec. 7, 2015.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, financials edition. We're calling this week's episode: "It could happen to you when the rubber hits the road -- for financial companies." I'm Gaby Lapera and John Maxfield is joining us on the phone.

Speaking of rubber, let's talk about Medallion Financial. Maxfield, do you want to do a quick recap for our listeners about what Medallion does?

John Maxfield: Sure. So Medallion is, I love that name by the way. Isn't that awesome? Like Medallion. It reminds me of I'm in an episode of Zelda or something like that and I'm looking for a hidden cave.

Lapera: Yeah. It makes it sound like winners, you know? Like first-place winners.

Maxfield: Exactly. But it's like the fancy way of saying that you're a winner. You know what I mean? I got a medallion. Whereas like me I got participation ribbons. But I tried my hardest, I'll say that. So Medallion, what Medallion does it invest in...

OK, let me actually start in a different place. So, if you want to drive a taxi in a big city like Chicago or New York, you can't just go get in your car, paint it yellow, put a little light on top, and then drive it around the city picking up people, right? You've got to get licensed, and in order to get licensed, you have to basically buy a medallion and then that gives you a right to drive a taxi in a particular city for so long.

Well, those medallions have been going for over a million dollars in New York City for quite a while, which leads you to believe that driving taxis isn't such a bad business in New York City. And they were going for something like $350,000 or $330,000 I think it was a year or I don't know what the time period was in Chicago.

Lapera: A couple years ago in Chicago, yeah.

Maxfield: Yeah and these, the prices of medallions, these medallions have dropped something like 50% [Editor's Note: Medallion notes in their Q3 2015 10-Q that medallion values have declined by 32% for individual medallions and 39% for corporate medallions in NYC, and 33% in Chicago] since Uber and Lyft and these other companies have started introducing new competition in the taxi industry. And so this has left not only the taxi industry in somewhat of a lurch, but also financial companies like Medallion that financed the purchase of these medallions.

Lapera: Right. So there's a couple things that Medallion does. It owns a bunch of its own medallions that it leases, as well as giving out loans for other people who want to buy medallions from other places. Just to make that clear.

Maxfield: Right. And so then when you think about it from a bank's perspective, when these prices on these medallions plummet and these are the things that are collateral for their loans, it's big, big trouble for the financial industry, for those financial players -- let me be specific -- for those financial players that focus in this area.

Lapera: Just to give some hard numbers here so people have an idea of what we're talking about. The example that you gave for Chicago in 2014, medallions were at around $350,000 and four this year have sold for $150,000 out of, I believe, foreclosures, which is crazy.

Maxfield: I mean it's just crazy and not only it's the magnitude of the drop but the speed at which it happened. Because, like you said, it happened over the course of 12 months. For anybody who's interested in this topic, we want to let you know that one of our colleagues, a young man named Jordan Wathen -- he's an incredibly talented writer -- has followed this story for what, Gaby? A year now? And writes really great stuff on this, so you can find all this stuff. You can just Google Jordan Wathen and medallions and really get the whole back story on this.

Lapera: Absolutely. But this being The Motley Fool, we have some Foolish advice I suppose. So there are a ton of learning opportunities here, right? Because Medallion really thought it was on top of the world back in 2011. I had just graduated from college back then, and I moved to DC and I was taking cabs absolutely all the time because I was working in the service industry.

So I'd get out around four in the morning and I didn't want to catch a bus home, so I'd try and grab a taxi. Because I had all my cash tip money and I also didn't want to get mugged. And I'm not going to say I had the best experiences with taxi drivers. Sometimes I had really great experiences and they told me all about their lives, and they're really friendly. And then one time I actually almost got hit by a cab driver. I was trying to get into his cab, tell him where I wanted to go, and he said, "I don't want to go there" and just drove off. My hand was still in the door. The cop actually pulled him over a block down the way because apparently it looked that close.

But Uber and Lyft, like you said, have taken market share. Medallion thought it was on top of the world back in 2011 and then something came along that no one expected in the form of the tech innovation. And this is going to keep happening more and more as the pace of the technology industry accelerates.

This is a reality that could happen to any company. But there are some things that you as an investor can do to help insulate yourself from these kinds of risks. And I know we harp on this a lot on this podcast, but diversity is critical to every portfolio -- both having a wide variety of companies as well as having companies that offer a wide variety of products. So even if one business segment bites the dust, they still have other ways of keeping themselves going.

Maxfield: Yeah. And that's a really, really critical thing because you have to match up what Gaby's saying. There are these industries and you can think that an industry is completely protected from competitors because there's nobody else there. There's nobody else providing those services. But then some sort of technological innovation will come along and completely decimate or completely disrupt an industry.

Back when, in the early 1900s, when you had cars come out. For the longest time, nobody thought that automobiles were going to be, they thought it was just going to be kind of a niche hobby market. But then it came out and totally disrupted the horse-and-buggy market. And it was just completely unseen.

So it's important for investors, the one way to protect yourself from this, because you can invest in a good company for 30 years and it can be a good decision, and they could get disrupted in 15 years.

The best way to protect yourself is just diversifying and you can do that by either buying just a bunch of individual stocks or probably the easiest way and probably the most sure way to diversify your portfolio adequately, is just to buy an exchange-traded fund and invest in, say, the S&P 500.

Lapera: Absolutely. And then like I was saying about companies that have diverse business lines. You have, say, for example, GE, right? They have energy, aviation, healthcare, transportation. They even had GE Financial for a while, which they're spinning off and selling off to different people. But they basically ran a bank. I don't think a lot of people knew that GE essentially had a bank within itself for a really long time. It wasn't doing great so now they're selling it off.

Maxfield: And it was a huge bank.

Lapera: It's a huge bank.

Maxfield: I think in asset sizes and they run off some of their assets and this has since been sold off, and I think it operates under the name Ally Bank now, right? That used to be GEs, if I'm correct. And it's a huge bank. I think it's a top 10.

Lapera: Oh yeah, absolutely. But when people think GE, they don't think about that. They think about washing machines. They definitely don't think about them making airplane stuff, either, you know? But they have a lot of different things.

Another one is Procter & Gamble or Johnson & Johnson. They just have so many different business lines that people don't even think about. Johnson & Johnson, for example, makes surgical instruments. A lot of people have no idea. They just think of them in terms of Band-Aids.

Maxfield: Yeah, yeah. And so you know, you're looking at Procter & Gamble or Johnson -- these are your definitional companies that have internally diversified their product lines. And, say, if you're looking at a company that's focusing exclusively on medallions or overfocusing on them, you really can see the impact of not diversifying because of what that will do to your revenue stream.

Or as opposed to your companies that Gaby was just talking about, you can have one business go down, other businesses will pick up the slack.

Lapera: Absolutely. The other thing that you want to look at and something that all these really big businesses have done, is that they have weathered adverse business cycles where innovation or bad market conditions could've killed them but they didn't. That means you're going to be looking for companies that are highly adaptive and able to pivot to meet new challenges or environments.

The business that comes to mind for me, because we do financials, is actually Community Bank System. They're a small bank system that's up in New York and they actually thrived during the financial crisis because what they did was -- a lot of the bigger banks, they pulled out of the really small towns there because it was hard for them to be profitable there -- and Community Bank System just swept up, scooped up all those little banks, all those little small towns, because those people still had to bank and there was no one to fill that void. And now bigger banks are having a hard time moving back into those small towns because everyone is with Community Bank System. Pretty smart.

Maxfield: Yeah, that's smart. You know, Gaby, I've not looked into that company. I'm going to have to take a look at that.

Lapera: Oh, yeah, absolutely. We can talk about it one day. It will be pretty exciting. Actually talking about banks, do you want to talk about Silicon Valley Bank?

Maxfield: Sure, yeah. Silicon Valley Bank is another ... One of the things that Gaby and I have talked about a lot on this show is that when you're looking at not only just a company but a bank in particular. And this comes from our favorite investor, Warren Buffett. The things that you're looking for are either a bank that is in a particular niche -- and a company that we've talked a lot about is in a particular niche over the last few months is New York Community Bancorp -- but another bank that falls into that niche is Silicon Valley Bank.

And so when you're in a niche like that, what it allows you to do is to earn excess profits over your competitors. Because you can have wider margins because either you're specializing in a thing or somehow you've differentiated your product. What Silicon Valley Bank does, is it provides banking services to, guess where? Silicon Valley, right? So all your new start-ups. So a new start-up will come in, it will need, you know, treasury management services, it will need deposit accounts, it will need checking accounts, it will need loans -- all these different things. Where do they go? They go to Silicon Valley Bank.

And there are a number of really, really interesting things that come from this. The first is that if you look at Silicon Valley Bank... Most banks what they do is they borrow money really inexpensively from depositors and then they invest that money into much higher interest-earning assets, namely loans. Well, what Silicon Valley Bank does is it has so much free money in terms of deposits... Let me make sure my numbers are right here. Out of roughly $40 billion worth of liabilities, get this: $31 billion worth are interest-free deposits.

Lapera: That's insane.

Maxfield: Think about that for a second. This is a bank that 78% of its financing is free. I mean it's unbelievable and the reason its financing is free is because all of these Silicon Valley Banks put all of their excess deposits in there and they get all those excess deposits from your venture capitalists. So then what Silicon Valley Bank can do with this, is because their funds are so inexpensive, they don't have to make as many loans as many of their competitors do to earn as much money.

So what that means is that it can then go and invest a lot of those cheap deposits into extremely safe securities, like government securities are AAA rated, right? I can't remember if our government is AAA rated anymore or not. Or AAA-, or AA+. But it's basically as safe as you can get. And it can still earn all this money, reduce credit risk, and serve this particular niche market. And it's just been a great thing for Silicon Valley Bank's investors over the years. It's been able to compound at a faster rate than many of its competitors.

Lapera: Yeah. Actually I was just thinking do you want to comment on, because we were just talking about how it's really important to have a company that has diverse business interests. And we were just harping on Medallion for being a niche lender. So what do you think about that in terms of Silicon Valley?

Maxfield: That's a really good point, Gaby. The benefit of being heavily concentrated in Silicon Valley are all the things I've talked about. The detriment obviously is that if something happens where all your venture capital financing or something impacts the tech sector, like, say, the tech bubble when that burst in 1999 or 2000, that is going to hit Silicon Valley Bank.

So it's not as diversified as your Wells Fargo or U.S. Bancorp is, so that is a risk you're going to take. But, so far, it has offset that risk with higher returns.

Lapera: Absolutely. And actually one of the really interesting things about them is, like you said, their venture capitalists, their investing in the tech industry, which is really the biggest source of innovation in the country right now.

A lot of the people that they have or not a lot but some of the people they have sponsored have been huge winners like Cisco, Twitter, I believe they also had Facebook for a little bit, I'd have to check on that one. Uber was another one that they had, speaking about transportation.

Maxfield: And here's what is another really unique thing about this, and this goes to show why this has worked so well for Silicon Valley Bank. All of those companies, a lot of times when Silicon Valley Bank goes in, you either finance, help them finance a deal, or to provide services that they will take warrants in these companies, which are derivatives, which gives Silicon Valley Bank the opportunity to buy shares in these companies at set prices and often times when you exercise those warrants, those prices in the actual companies are much higher than the warrant price.

So when you look at Silicon Valley Banks' income statement, its top two non-interest income sources and this is really unusual for a bank, are gains or losses from these types of instruments.

Lapera: Yeah that's really cool. The other thing that was really interesting about this bank to me is that it operates a little bit more like a small bank would, like a little small town bank where if people are having trouble repaying their loans and they really think that they've got a good shot, they just need more time, they'll give people extensions. It's that the lot more of a humanitarian approach to finances than you're used to seeing with banks.

Maxfield: Yeah and I think you're talking about that Wall Street Journal article where they're talking about there's a ... I can't remember the name of the company, it was TinyCo or something like that. Where they were in breach of their loan covenants because I guess they'd missed a loan payment or something was going on there.

I don't know if it was a loan payment or maybe some of their financial ratios got off-kilter, and they went back to Silicon Valley Bank and they got something like a six-month extension. And then they were able to turn things around and then pay off their loan. So forbearance in certain instances certainly pays off.

Lapera: Absolutely. Anything more you want to say about that? Or do you want to move on to our next topic?

Maxfield: No, nothing in particular. Just that if you're looking for a niche bank, this is one you're going to want to throw into your kind of analysis.

Lapera: This might be a good way to help diversify your portfolio as long as you don't put all of your money in one place.

Maxfield: That's right.

Lapera: Fair?

Maxfield: That's right. Fair.

Lapera: There is another article that we saw on Wall Street Journal that some insurers are actually raising rates on life insurance policies that they sold back in the '80s. And this is for a special type of insurance called universal life insurance, which is kind of like a combo life insurance slash savings account-type deal and has tax advantages on it. And this is really unusual.

Most of the time insurers do not raise prices on customers, especially ones that they've had for so long and the increase in price can be anywhere from they said the lowest was going to be like $150. But for people who have millions and millions and millions of dollars in these accounts, then it could be over six figures.

Maxfield: This just goes to show that low interest rates don't only hit banks. Insurers are just really, really struggling right now to make any money. And if they're not able to make money, they've got to adjust in some way and evidently raising rates on long-term existing customers, it's gotten so dire that that's where they feel like they need to go.

Lapera: Absolutely and let's back up a little bit and explain to people. So federal interest rates, like we've said many times before on this program, are extremely low right now. Historically low. They pretty much can't get any lower than they are. And the gossip mill watercooler of the Fed is saying that eventually they'll probably raise them, probably pretty soon.

Maxfield: Probably this month.

Lapera: Probably this month, which we've said every month since June I think.

Maxfield: Exactly. Since last June.

Lapera: But maybe probably this month. And when interest rates are this low it means that insurance companies who are, normally have these funds and kind of safe investments, they can't make as much money on them. To the point that apparently they're starting to lose money and they can't keep the investments up.

Maxfield: Yeah. This is just a bad time for insurance companies, and it's a bad time for banks. And even if you're not even interested in investing in an insurance company, because they are struggling to make money off their investment through their securities portfolios because of these ridiculously low interest rates. But the angle to look at this from is not necessary just as an investor, but also somebody who's looking for life insurance.

When interest rates are low like this, life insurance is just going to cost a lot more. So you can even think about life insurance from the perspective of kind of looking at it as a contrarian investor and then to wait until actually purchasing it for yourself or a large policy for yourself. Maybe buy an intermediate policy to buy you some years. And then buy your large policy, wait until interest rates have gone up a little bit, and the price of those policies have gone down.

Lapera: Absolutely. I think that we should do show on insurance sometime. I think it will be really exciting, don't you?

Maxfield: On insurance?

Lapera: Yes.

Maxfield: Captivating.

Lapera: I know it's just that what makes our blood fire. Anyway, I think that's it for today. Anything else you want to add?

Maxfield: That's all I've got for you.

Lapera: All right. Great! As usual, people on the program may have interest in the stocks they talk about and The Motley Fool may have recommendations for or against. So don't buy or sell stocks based solely on what you hear. Thanks for joining us! I hope you like this week's episode. Join us next week. I think we're going to be talking about books. Write to us at [email protected] to tell us about your favorite financial stocks.

Editor's note: This version has been updated to reflect that Medallion Financial wasn't previously the exclusive medallion financier in cities such as New York, Chicago, or Boston. In addition, text alluding to losses suffered by Medallion has been removed, as any bottom-line losses that may or may not materialize at Medallion have yet to do so. There are few other notes  and adjustments throughout the article as well to clarify and give context.