Want to know how banks like Citigroup (C 2.21%) and Bank of America (BAC 1.40%) destroy shareholder value? They chase short-term revenue growth at the expense of credit risk.
It isn't all about revenue growth
I was reminded of this recently when reading over the comments that former-Citigroup CEO Chuck Prince made at the end of 2006.
"After a number of years of no real organic revenue growth in this business, driving organic revenue growth is absolutely key for Citigroup to be a growth company," he said on the third-quarter conference call.
He reiterated the point later in the presentation, saying: "I can't overemphasize the need to invest to drive revenue growth. The issue for our company, given our size, is driving revenue growth."
Altogether, he mentioned "revenue growth" a full 17 times in his introductory remarks.
Suffice it to say, we all know how this story ends. In 2008 and 2009, the company's inattention to credit risk cost it more than $60 billion in pre-tax earnings.
And the same thing happened to Bank of America.
Around the time Prince was promoting growth above all else, the Charlotte-based bank was in the midst of yet another acquisition frenzy. It merged with FleetBoston Financial in 2004, acquired U.S. Trust one year later, and in 2007, it made its first fateful investment in Countrywide Financial.
Since then, it's shelled out almost $50 billion on legal charges and expenses largely related to its over-aggressive strategy of growth-by-acquisition.
A rule to protect your portfolio from bad bank stocks
I don't bring this up now to suggest that banks are on the verge of another growth binge followed by a credit debacle. As U.S. Bancorp's chairman and CEO Richard Davis recently pointed out, credit concerns are far from the industry's biggest issue at present:
This recession is so long that we haven't originated any risky loans, and the other ones have been either charged off or paid down. So you are at your most pristine. I mean, credit quality is so 2009, right? And it if you think about, if banks stay prudent and I already gave you my sense that the regulators are going to make sure you do. You could be talking half a generation until companies get back to the same kind of credit position that they were before this recession.
But -- and this is critical to appreciate if you invest in the banking sector for the long term -- this cycle will happen again. It may not be next year or even within the next decade. But it will happen, and when it does, it will swallow up many of the small and regional banks that commentators and bank analysts are touting today.
How can you, as a bank investor, avoid this fate? It's simple: Subordinate growth to credit quality -- and specifically, a demonstrated history of prudent risk management -- in your analysis of bank stocks.
While your short-term returns may suffer, you'll thank yourself in the long run.
