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I am pleased to start a new series today entitled “how to invest series” which looks at how to invest in stocks in various industries. The inspiration for this series are from reader questions asking me why a certain stock in an industry performs better than their industry peers or, regardless of whether you are an active or passive investor, what all this jargon means when stock analysts talk about a stock.

I am starting with investing in banking stocks; an industry which, obviously, is under a lot of attention lately. My next post in this series will be on REITs. Let me know if you have any other suggestions. Thanks.

Banks- how does it make money?

Originally, we lend it money through deposits and they lend it to borrower. The spread between the interest payable to you and I and the interest received from borrowers is called the net interest income and a profit center.  Most banks now divide their personal banking (you and I) from their commercial or wholesale banking (loans to other banks or businesses).

Over time, banks have branched out into other business lines like investment banking (earn fees on advisory services or underwriting a business going to market), trading (using deposit and shareholder equity to trade in the market), insurance (earns money between premium paid and premium paid out) and selling product (earn management fees on mutual funds).

Banks- what are important factors to consider?

Banks are in the business of risk management. Thus, on a non-exhaustive basis, you need to look at how it manages its risk by looking at:

1. Bank’s capital base: In other words, if the banks manage their risk poorly, do they have enough assets to weather the storm? If the bank lends out a $500,000 mortgage which defaults and only recovers $300,000, the $200,000 loss has to be paid out of retained earnings or shareholder equity. Multiple this loss by hundreds of thousands of times and you understand why a bank could be in trouble if it doesn’t have a lot of cash on hand. Typically, one looks at equity (usually common shares plus retained earnings plus preference shares) over assets to determine how strong a capital base is. This is known as a tier 1 capital ratio. A tier 1 one capital ratio in the high single-digits (8-9%) is considered healthy; recently, some banks have a tier 1 capital ratio of 10.  All banks provide tier 1 capital ratios so it is easy to look up.
2. Loan loss reserve. This is a portion of money set aside to cover losses on loans due to partial or full loss. A low loan loss reserve is desirable. A high-reserve relative to competitors tells an investor: (i) bank is not good at risk management; (ii) less money can be used to make new loans, slowing the growth of the business.

Assuming the bank is managing its risk properly (the defensive side of the equation), then you shift your analysis at how effective a bank is at making money (the offensive side of the equation). In addition to the usual net revenue and earnings growth, you are looking at some bank specific metrics as well:

1. …A note on return on equity (“ROE”). This is a ratio is calculated by dividing net income over shareholders equity and shows you how much profit the bank has made with shareholders’ money. ROE in banks have been around the mid teens to mid-twenties for most of this decade but banks are already warning investors that this is unrealistic going forward giving the risk taken to achieve this type of ROE. Some banks have  already talked about ROE of high single digits when the dust settles fully on the credit crisis.
2. Efficiency ratio. In plain English, this ratio measures how efficient the bank is at running its operations by looking at operating costs/net revenue (in other words, how many cents on every dollar made goes to costs). The lower the ratio the better. A ratio in the 50’s is great (Wells Fargo’s ratio is approximately 56 as of Q2 2009; Bank of America is 49.62). Having said that, you have to be cautious about efficiency ratios. A business can decrease it quickly by laying off a lot of employees which is good for the short-term but may slow growth long-term.
3. Deposit growth. A bank’s life-line is growing its deposit base. What you are looking for is growth in total core deposits year over year (a core deposit is a deposit considered to be long-term). In a large bank, core deposit growth of 4-6%  year over year would be considered a good growth rate.
4. Net interest margin. As discussed above, this is the spread between the interest received from borrowers and interest paid to deposit-holders. A margin between 3-4 is considered ideal for investors. For example, Wells Fargo’s  net interest of margin of 4.16 in the last quarter is the highest among all the large banks.

Banks- the common sense approach

Finally, I would highly suggest investing in a bank you use or that operates in your area. You can make some sense of the bank’s future prospects by simply seeing how well the bank runs and treats you. For example, CIBC is not a name you hear much of in personal and small business banking and, from professional experience, my dealings with their front-line bankers do not exactly inspire confidence. Thus, it is not surprising that the market considers this bank to trail its peers.