Some stocks are for investors. Others are for speculators. When it comes to bank stocks, BofI Holding (NASDAQ:AX) falls into the latter category.
Does this mean you shouldn't buy its stock? Not necessarily. But if you do, you should do so with your eyes wide open.
As I discuss below, while BofI Holding's widely heralded business model is yielding market-leading growth figures, it's also exposing shareholders to a higher degree of risk than is necessary when you consider the alternatives in the banking space.
What many analysts and investors don't appreciate about banks is how easy they are to grow. I don't mean that in a theoretical or detached manner. I mean it literally; it's extremely easy to grow a bank.
Assuming you've gotten your hands on a bank charter, all you need to do is attract deposits by paying a higher interest rate than your competitors. You then loan that money out to people who want to buy an asset or pursue some other type of speculative business venture.
Depositors will flock to you irrespective of your reputation or business savvy because the funds are federally insured by the FDIC. And there are plenty of prospective borrowers who are willing to take your money, never mind the fact that some of them won't be willing or able to pay it back when the time comes.
The list of banks that have used this model and subsequently ended up in the financial industry's graveyard is long and illustrious. It's one of the main reasons, for instance, that hundreds of savings and loan institutions failed in the banking crisis of the 1980s.
Thus, the trick is not simply to grow a bank. It's rather to grow one in a responsible and profitable manner -- that is, by securing cheap and stable deposits and only lending money out to reputable borrowers.
It's for this reason that investors should always be highly suspicious of a bank like BofI Holding that's using a model like the one described here to grow quickly (though, to be clear, we won't know the true quality of BofI Holding's asset portfolio until the next downturn). To an experienced analyst, that is a vice, not a virtue.
2. Vulnerability to liquidity runs
Even if BofI Holding isn't originating bad loans or holding potentially toxic assets on its balance sheet, there's another equally grave risk that's inherent in its business model -- a liquidity crisis.
As a general rule, retail deposits are both a cheap and stable source of funds for a bank. This is the reason that lenders like Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) have such bright futures despite their current legal and regulatory struggles -- this is assuming that they address the reputational challenges that could inhibit future growth and profitability. These two banks alone control roughly a quarter of the nation's deposits, a large portion of which, it's worth noting, consists of noninterest-bearing demand deposits.
BofI Holding, on the other hand, relies to a large extent on so-called "hot" money -- that is, deposits that are parked there merely because of the bank's high interest rate as opposed to the services and conveniences that it provides. Consequently, if the interest rate environment ever turned against BofI Holding, it isn't unreasonable to assume that many of these deposits would flee to higher-yielding homes.
History is replete with liquidity runs like the hypothetical one described here, and they've been known to claim the lives of even highly solvent entities.
3. BofI Holding isn't tried and true
Last but not least, if there's one piece of advice I'd give investors about bank stocks, it's this: Buy the best.
It isn't a coincidence that the biggest bank holdings in Warren Buffett's portfolio at Berkshire Hathaway are Wells Fargo, US Bancorp, and M&T Bank. These are phenomenal banks, led by phenomenal executives, with many decades of experience in the industry.
While BofI Holding may get to this point someday -- though, largely for the reasons outlined above, I highly doubt it -- it's a long way from there now. And the path between here and there is teeming with danger, dilution, and potentially even failure.
Call me a cynic, but it simply isn't worth the risk.