The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Nov. 8. With permission, we're reproducing it here in an edited form.
It was, as it's wont to be, another confusing earnings season for the "too big to fail" banks in the United States and Europe. Citigroup (NYSE: C) beat expectations, but then longtime CEO Vikram Pandit was forced out. JPMorgan (NYSE: JPM) reported record profits thanks to a rise in mortgage refinancing, a quarter that looked particularly good next to the debacle that was Q2. And Goldman Sachs (NYSE: GS) sent a mixed signal, posting higher profits but continuing to lay off employees.
While these reports and more elicited great interest from politicians, regulators, and the media, we didn't pay much attention to them at Motley Fool Asset Management. That's because these reports, due to their relatively simplistic treatment of financial activities and securities of tremendous scope and complexity, simply cannot provide a clear picture of what is actually going on at any of these banks or what their health will be over the very long term.
What's more, it's not clear that the powerful people running these financial institutions even know all of the dangerous details of what lurks on their balance sheets. Consider, for example, what was revealed in a recent New York Times Magazine profile of former JPMorgan Chief Investment Officer Ina Drew. An executive who sat in on a meeting between Drew and the traders who ultimately cost the bank some $6 billion remembered that the traders managing the trade "did not give as full an answer as they could have" to an expert executive, who then failed to ask the right follow-up questions. Even worse, the bank eventually had to restate earnings because traders had not been correctly measuring the magnitude of their losses -- perhaps by mistake, or perhaps to hide them.
Let's be clear
This lack of transparency and understanding is not a phenomenon unique to JPMorgan. It was the reason AIG (NYSE: AIG) kept selling subprime mortgage insurance (on portfolios stacked against it, no less) to Goldman Sachs and the reason Bank of America (NYSE: BAC) consummated a disastrous acquisition of Countrywide Financial. Simply put, neither of these institutions really knew what they were doing.
And if the professionals who work at these firms and who have direct access to the people and information they need to make smart decisions about their business cannot do so, how can investors be expected to make smart decisions about the stocks? The answer is they cannot, and that's why we consider this incomprehensible segment of the market to be almost entirely uninvestable.
This is not to say that there is no opportunity in bank stocks. The fact is that the iShares Global Financials ETF has lagged the market over the trailing one-, two-, and five-year periods by staggeringly wide amounts, with investors' around the world souring on the sector writ large. Whenever something has done that bad for that long, an investor may benefit simply from a sharp reversion to the mean.
But the opportunity in the financial sector for investors is even more interesting than that. See, not all banking is too-big-to-fail banking. By asking three simple questions of our financial sector stocks, we believe we have filled the portfolios we manage with firms that have comprehensible financial statements but incomprehensible valuations.
Here are those questions:
- Will you stay within your circle of competence?
- Are you run conservatively?
- Can we determine from your financial statements that your business is either thriving or improving?
There aren't many global financial institutions that can answer "yes" to all three of these questions. Here are three that have for us.
This Latin American trade bank has one mission: to promote foreign trade throughout Latin America, and it does so by issuing short-duration loans to other banks and corporations, with a risk committee making sure that its country allocations are appropriate. This isn't a flashy business, earning a relatively measly 1.8% net interest margin and 1.5% return on assets, but the bank has consistently created value for shareholders doing it, with recent expansion plans seeking to slightly lengthen the terms of some of the loans the bank will make. Given the short-term nature of the loans, it's relatively easy to get a picture of how the bank is doing in its monthly reports to its regulator, and management did a good job capping exposure to one potentially disastrous dalliance into asset management. All told, Latin America may be a volatile region, but this bank is a rock.
Suffolk Bancorp (NYSE:SCNB)
The only U.S. bank we own, Suffolk Bancorp has not always been well-run. That said, with a cost of funds that recently checked in at less than 50 basis points thanks to the bank's small-but-loyal customer base on the East End of Long Island, new management simply needs to avoid obvious missteps in order to create significant value for shareholders. Improved disclosures have shown that the quality of the bank's loan book is improving and that management is executing on its promise to clean up the mistakes of the previous regime.
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A Mexican microfinance institution may not seem like a bastion of financial conservatism, but like Bladex, this bank's short-duration loan book makes it relatively easy to get a picture of how things are going month to month, with bad bets being recognized sooner rather than later. What's more, the bank got its start lending to what it discovered was the safest part of the microfinance pool: groups of rural female entrepreneurs. And while growth to serve cities, men, individuals, and other countries has temporarily dinged returns, we don't think management's mind-set to run a conservative microfinance book has changed at all.
The way to invest in financials in the wake of the recent crisis is not to swear them off entirely. That's because many have done that, thereby creating pockets of opportunity. But as you look for financial sector stocks worth owning for the long term, do what we have done, and seek out those that stick to their knitting, run conservative books with little leverage and low cost of funds, and can demonstrate to you unequivocally that business is good.
Editor's note: Tim Hanson is not able to engage in discussion on the boards or in the comments section below. Tim owns shares of Bladex.