The SAVR Checklist for Analyzing Financials (Banks)

Transcription

1 The SAVR Checklist for Analyzing Financials (Banks) LET S REMOVE THE BLACK BOX POPE@BRARIFUNDS.COM It s a black box. Too much risk. I don t understand banks. These are the common statements one hears with the mention of a bank as a potential investment. The recent financial crisis has negatively impacted the perception of banks and revealed hidden spider webs in the financial statements. The following checklist is based on our analysis of banks, and includes past mistakes of great investors such as Warren Buffett, Bruce Berkowitz, Peter Lynch and more. The checklist focuses on the four pillars of our investment analysis: 1. Sustainability of the business model, 2. Accountability of the management, 3. Value of the investment, 4. Risk factors (i.e. Business/Emotional Risk and Leverage). The factors are discussed in the approximate 35+ item checklist for analyzing a bank. Sustainability of the Bank What is the competitive advantage "niche"? (i.e. Regional advantage, low cost, product offering, economies of scale). What is the composition of earnings growth over the past five years? (i.e. Organic, buy-backs, M&A) What is the bank s cost-to-income ratio vs. peers? Cost/income ratio is the ratio derived from operating expenses and operating income. The ratio measures the proportion of bank s income that is consumed by operating costs. It is a key performance indicator of a bank's efficiency. The smaller the ratio, the more efficient is the bank. Have I performed peer analysis? Have I compared the following? a. Net interest margin b. Expense ratio as a percent of revenue c. Overhead efficiency ratio

2 * Efficiency ratio - measures non-interest expense/operating costs as percentage of net revenues. (good banks have efficiency ratios under 55%; lower is better). * Net interest margin - (the spread banks earn between deposits and loans), interest margin as percentage of average earning assets (3-4% average, look for trend), but look at interest rates - falling rates = higher margins, but check type of lending cars = higher than house. What is the Return on Equity (ROE) vs. historical data? How did the bank overcome the previous recession? Did it undertake risky lending and suffer substantial loan loss? Alert, a sign of poor risk taking by management. What is the 5-Year Growth Rate of Earnings per Share vs. current valuation based on PE/PB? A bank is a business like any, we do not want to over pay for growth. Traditionally, we equate the PE multiple to the long term growth rate of earnings. If the company is enjoying regional success, can it be extended nationally? If the bank is focused on sales region, have I checked for recent population and economic growth? The bank s revenue growth will most likely follow the same pattern. Accountability of the Management Have I analyzed for quality of the management? What is the rate of insider ownership? This is the most important area for banks, as management is responsible for risk-taking. Does the CEO have a good track record (M&A and operational)? Check annual letters and history of profitable lending and earnings growth. How has the management allocated capital in the past? Have they announced changes to their capital allocation strategy? Are there frequent write-downs? If not, have I added back one-time charges? Value of the Investment What is earnings per share power after provisioning for potential loan loss? * Loan Loss Provision = Total Amount of Loan - Expected Loan Loss * Loan Loss Provisions: the loan loss provision is a balance sheet account that represents a bank's estimate of potential loan losses. For example, let s say a bank extends a $1m to a retailer for 5 years. If two years later, the retailer runs into financial problems, the bank will create a provision for loan loss. If the bank estimates that the client will only pay back $400k of the total $1m loan or 40%, the bank will record a provision for a loan loss of $600k (Total Amount of Loan Expected Loan Loss). To be conservative, many times banks will over estimate loan loss provisions. As the recession fades, they

3 are left with a surplus in their estimates. To achieve realistic earnings estimates going forward, it pays to estimate the normalized earnings power per share without loan loss provisions. How much is reserved for provisions vs. actual net charge-offs? *Net charge-offs: After creating a loan loss provision for a troubled loan, the bank can estimate the amount the borrower can repay. The bank also determines the amount of the loan that will not be repaid. In the example above, if the bank can only collect $200m out of the $1m loan, the net charge off will be $800k. Has the bank over-reserved for losses? Typically banks over-reserve to be conservative. As the recession fades, surplus reserves add to earnings. Bruce Berkowitz on his Wells Fargo investment in 1992 (Outstanding Investor Digest): Its earnings power has been disguised by the intense provisioning for loan losses. But when the provisioning gets back to a normal level, you ll start to see that incredible earnings power come down to the bottom line. And it s as simple as that. Have I checked for the current book value verses historical data and peers? Historically large banks typically sold for more than 1.5x book value. Most of the assets of a bank are in the loans. If you are convinced the bank has avoided high-risk lending, you can begin to have confidence in the book value. Berkowitz elaborating on his Wells Fargo investment in 1992: Wells Fargo began to fix its problems in several fundamental ways in the early 1990 s. However, the m arket did not reflect these changes in revaluing the stock s price until years after the improvements began. Is the bank buying back shares? What is the average price paid in previous buy-backs? (Should be lower than current share price). Risk Factors How will high unemployment rates and economic recession hurt the business? How have earnings behaved in the past recession? What is the bank s exposure to a possible macro-economic shock? (indirect or direct, e.g. US housing) Is the bank involved in any significant lawsuit(s)? What are loan loss provisions as a percentage of total loans? The ratio should improve as the recession fades. A consistent increase in an alert for risky lending. What is the trend for non-performing loans? Has the level stabilized? What are the loan loss provisions as a percentage of the pretax profits? What is the bank s debt rating and preferred debt rating? What is the growth rate of loans? Rapid growth in loans potentially means the bank is not carefully evaluating its loan portfolio.

4 Have I tracked deposit levels? Are they growing or declining? A decline could mean the customers are taking their deposits elsewhere. Is the equity of the bank declining? Watch out the last layer of protection. What is the estimated normalized earnings power in regular economic times? Have I checked for the Equity to Assets ratio? The most important number of all; it measures financial strength and survivability. The higher the E/A, the better. E/A s have a wide range, from as low as 1 or 2 (candidates potentially headed for disaster) to as high as 20. An E/A of 5 to 6 is average, below 5 is the danger zone. Prior to investing we prefer to see that its E/A ratio is at least 7. What is the percentage of Real Estate Owned (REO)? This is property on which the bank has already foreclosed, watch out for rise in REO, it s not the bank s core business. Commercial loans are more risky than others. What percentage of the loans outstanding are commercial? Ensure it s below 10% or else potential for a large disappointment. Is the bank operating in a risky geographic area with corporate governance and/or political issues? (Country exposure: check for credit growth, 90-day non-performing loans; watch real estate prices vs. historically normalized levels). Are my investments too concentrated on one industry financials (banks)? (Berkowitz recently had to wait at least 2-3 years for financials to rally). Am I ignoring things on this checklist because I feel too complacent or attached to my research?

5 Disclaimer Brar Investment Fund, LP is non diversified, which means that it invests in a smaller number of securities when compared to more diversified funds. Brar Investment Fund, LP tracks it s performance against the S&P 500 Index. Brar Investment Fund, LP is exposed to greater individual security volatility than the S&P 500 Index and diversified funds. Brar Investment Fund, LP can invest in foreign securities which may involve greater volatility and political, economic, and currency risks and differences in accounting methods. Brar Investment Fund, LP may also invest in special situations to achieve its objectives. These strategies may involve greater risks than other fund strategies. Information provided reflects Brar Investment Fund, LP s views as of the date of this commentary. Such views are subject to change at any point without notice. Brar Investment Fund, LP obtained the information provided herein from third party sources believed to be reliable but it is not guaranteed. Brar Investment Fund, LP is not responsible for the consequences of any decisions or actions taken as a result of information provided herein and no investment decision should be made solely on the information provided. Brar Investment Fund, LP s investment objectives, risks, charges, and expenses should be considered carefully before investing. Nothing in this presentation should be taken as a recommendation to buy, hold, or sell certain securities or any other investment mentioned herein. Our opinion of a company s prospects should not be considered a guarantee of future events. Investors are reminded that there can be no assurance that past performance will continue, and that a private fund s current and future portfolio holdings always are subject to risk. As with all private funds, investing in Brar Investment Fund, LP involves risk including potential loss of principal. This document does not constitute an offer to sell, or a solicitation of an offer to buy membership interests in Brar Investment Fund, LP. We will not make such offer or solicitation prior to the delivery of a definitive offering memorandum and other materials relating to the matters herein. Before making an investment decision with respect to the fund, we advise potential investors to carefully read the offering memorandum, the operating agreement, the related subscription documents, and to consult with their tax, legal and financial advisors. The fund is offered to accredited and qualified investors. The securities are being offered in reliance on an exemption from investment company registration. Past performance is not necessarily indicative of future results. There should be no assumption that any specific portfolio securities identified and described herein were or will be profitable. Brar Investment Fund, LP may, at any time, reevaluate its holdings in any such positions. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. All investments involve risk including the loss of principal. This document may not be redistributed without the written consent of Brar Investment Capital, LLC and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Please contact us if you would like any materials such as our investment presentations or legal documents. We have compiled all information herein from sources we believe to be reliable but cannot guarantee its accuracy.