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Looking at Bank Stocks- back to the basics

Posted by admin on March 13, 2008 in Investment Products

Bank stocks are in a total free-fall (notwithstanding this week’s temporary relief where billions were thrown at a problem in the trillions) and, with it, much handwringing given that most of us hold one, if not multiple, bank stocks in our portfolio. It seems like stodgy bankers decided to become derivatives traders and, lo and behold, they managed to wipe billions of dollars off in their companies’ values and sent bank stocks in the gutter (now that’s a trick not even the most sophisticated of derivatives traders could have pulled off!). What do heck do we do now?

In a larger sense, and as preserve as this may seem, this blood-letting is good. It lets us see who really runs the best bank since they cannot rely on financial slight of hand and off-balance sheet transactions to report millions in profits. Banks have to make money the old fashion way- finding ways to attract and keep our money; a low-margin but fundamentally necessary way for the bank to leverage its way into higher leverage businesses such as wealth management, wholesale banking and insurance.

One of Warren Buffet’s favorite bank is Wells Fargo. Why? The bank has a reputation of being a strong “retail bank” (short-hand in the industry as a bank that knows how to attract your money and mine). At the end of the day, Wells Fargo knows how to attract money into its coffers no matter what the economic conditions are. Good banks know how to keep our money; bad banks rely on financial gimmickry.

Here is another example, the following is a list of mutual fund sales by the banks during RSP season as reported by the Investment Funds Institute of Canada (from largest number of sales to smallest):

1. RBC- $3.9 billion (even if you add in all the other financial institutions, RBC is first in sales by miles)
2. TD- $1.2 billion
3. CIBC- $795 million
4. Scotiabank- $352 million
5. BMO- $153 million

Since mutual fund sales are front-line sales products (they are sold in-branch, they are sold by investment advisors and the human face of any bank) sold to the retail market, it tends to be a good litmus test of which banks continue to do its core function well- getting money out of our wallets into their safe.

The sales numbers tend to match the strongest to weakest bank of the Big 5 and reinforces Big Blue’s reputation as the undisputed leader in Canada (not to mention a growing presence in parts of the U.S.). The anomaly in the group is Scotiabank which can be explained quite easily: anyone who follows the banking industry knows that Scotiabank’s Achilles’ heel is its wealth management section and its mutual fund division. They are huge challenges in Scotiabank breaking the grip of the “Big 2″ no matter how many foreign banks it acquires. Lest I be accused of selection bias, retail banking growth among the Big 5 follows a similar pattern with RBC and TD eating into the competition.

In looking at banks this year, I have avoided looking at dividend yield altogether (as Dividend4life writes, focusing on current dividend yield can be a fool’s game) and started looking at sales numbers. In a worse case scenario, every single one of these exotic financial instruments have to be written down and the bank goes back to its original function- keeping your money and mine “safe”. Thus, I have concentrated on who does retail banking the best since, in the long run, these are the banks I want to own.

The best way to do that is simply to look at who is opening new branches in your city and ask your teller if they are opening a lot of new accounts- yes, I am not even looking at balance sheets now (not that they disclose much these days) and doing some plain old observation. One banking analyst wrote this week that we should take a price to book rather than a price to earnings analysis to banks now- hard to do when you don’t know how much the book is really worth. Bank analysis has to be with our eyes and ears in the short term in addition to the traditional financial statement analysis.

The other thing to do is simply read research notes about market share growth in the retail sector of the bank (interestingly, BMO’s recent stumbles were preceded by warnings by observers that it was letting its retail operations slide…). Now to the $64,000 question…. no, I am not buying any banks now. I waiting for the other shoe to drop and have some mid-tier financial institution go under; every bubble seems to have some semi high-profile causality which usually marks the bottom.

(For full disclosure, I own both TD and RY.)