Large banks like Bank of America (NYSE:BAC) are such complicated entities that it can seem all but impossible for an outside investor to understand them enough to make a rational investment decision.
The Charlotte, North Carolina-based bank is huge. It currently has $2.3 trillion worth of assets on its balance sheet, ranging from loans and securities to intangible assets like mortgage-servicing rights and goodwill.
On top of this, as a universal bank, Bank of America has both commercial and investment banking operations. Within each of these are a multitude of business lines that operate according to different cycles. For instance, some of them benefit when interest rates rise, while others actually lose value.
Using mental models
One way to chip away at this complexity is to use mental models. These are structures or diagrams of an issue or topic that you construct and keep in your head. Then, when you're confronted with new information on the topic, you can more easily incorporate it into your model, remember it, and appreciate its significance.
"How do you think the most rational people in the world operate their minds? How do they make better decisions?" asks Shane Parrish, author of the Farnam Street blog. He continues, "They do it by mentally filing away a massive, but finite amount of fundamental, unchanging knowledge that can be used in evaluating the infinite number of unique scenarios which show up in the real world."
Parrish is one of the leading voices on the use of mental models, but he didn't come up with the idea himself. Instead, he got it from Charlie Munger, Warren Buffett's longtime business partner and the vice chairman of Berkshire Hathaway.
Here's Munger in a famous speech from 1990:
The first rule [to gain practical wisdom] is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.
You've got to have models in your head. And you've got to array your experience, both vicarious and direct, on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a latticework of models in your head.
A mental model of Bank of America
How does this relate to Bank of America? Its chairman and CEO, Brian Moynihan, offered an insight on the company's latest conference call that can help investors understand banks.
The insight came in Moynihan's prepared remarks on his explanation for the bank's ability to grow revenue in its operating segments despite a sharp decline in trading revenue, which is accounted for in Bank of America's global markets unit (emphasis added):
First, if you look at this quarter compared to a year ago, revenue grew 1% on a reported basis. And looking at the core lines of business without other, we grew revenue 4% despite the tough comparison for global markets. If you remove the global markets, you can see that the core annuity-oriented businesses of consumer banking, wealth management, and global banking grew revenue at 7%.
See that last point where Moynihan talks about "annuity-oriented businesses"?
That's the key.
What Moynihan is pointing out is that the vast majority of Bank of America's businesses produce stable, predictable earnings streams. It's only a few that don't. It stands to reason, in turn, that it's those few that are most likely to cause the bank's earnings to fluctuate sharply from quarter to quarter.
This insight helps one understand Bank of America better from an investment perspective. It does so by helping investors construct a mental model that isolates the variables and business units within the bank that drive its incremental performance in any given quarter.