How Lazy Investors Can Get Rich Buying Boring Banks
Have you ever woken up in the morning, alarm buzzing irrationally in your ear, and just felt lazy? Like Sunday morning don't get out of bed until 10am lazy? Ever wonder what it would be like to be act on that feeling, throwing caution to the wind, and just staying in bed?
A "purrfect" model for bank investors? Source: 3dpete
The reason I ask is simple; to be a good bank investor, this is exactly the kind of attitude you need. That's right, I said it. To win the long term banking game, the key is to find a boring bank, buy it, and then do nothing. Just stay in bed.
The glitz, glam, and complexity of Wall Street is for suckers
Complexity in banks is unnecessary. It adds risk. It creates opacity. But the "smartest guys in the room" don't want you to know that.
Have you ever read through a big bank's 10-K filing or annual report? I have, and its a painful experience. Hundreds of pages of esoteric accounting, debit value adjustments, interest rate risk tables, and on and on.
Charlie Chaplin on Wall Street in 1918. Pretty much the opposite of reading a bank 10K today.
And even more annoying, the big banks each have a unique approach to the business. Citigroup is following a global first strategy. Wells Fargo is pinning its future on the mortgage business here in the U.S. of A. JPMorgan Chase has perhaps the most complex balance sheet of any business in the world (seriously, does anyone really understand a balance sheet that includes $375 billion in "debt and equity instruments" and "derivative receivables"!?). Bank of America is working hard to be more like Wells, although the renovation still has a ways to go.
No one really understood the complexity back in 2007, and we all know where that ended up. And that's just the thing, banks in the traditional sense don't need to be all that complex. Its the crazy accounting gyrations and machinations that create "value" out of thin air that got us in trouble.
The folks over at The Federal Reserve Bank of New York's Liberty Street Economic's blog recently published a framework that illustrates the fundamental problem with all this complexity. It is really very simple, despite the academic writing style.
Banks essentially have two categories of assets and three categories of liabilities. On the asset side there is cash and other, riskier assets -- loans, securities, derivatives, and other investments. On the liability side, there is equity, short term debt, and long term debt.
Source: Liberty Street Economics
If the public loses confidence in the bank's investments, you have the makings of a potential bank run -- where customers en masse request to withdrawal their money. The bank would first satisfy the requests with cash. When the cash ran out, the bank would have to begin liquidating other assets. The more complex and hard to understand the asset, the more the bank must discount it or sell it quickly. The bigger the discount, the bigger the losses, and the more likely the bank is to collapse.
A run on a bank in the 1930's.
The vast majority of liabilities are short term debts comprised of customer deposits--checking accounts, savings accounts, or certificates of deposits. This is money consumers can withdraw more or less whenever they want, and its also money that the bank has used to invest in longer term, illiquid assets like loans or derivatives.
Investors, regulators, customers, and even other banks lose confidence very, very quickly when a problem arises and they can't understand the assets on a bank's balance sheet. Simple banking is better understood banking. Its repeatable. Its confident. Its boring. And its better.
A little complexity can help diversify income, and that's good, right?
At first blush, diversifying income streams seems like a great idea. Amazon.com went from $5 billion in sales to $75 billion by offering more than just books. Makes sense for banks too, right?
Not according to fellow Fool Anna Wroblewska. She writes that research from Kevin Stiroh of The Federal Reserve Bank of New York found that,
"there is a 'dark side to diversification': higher shares of non-interest income tend to increase risk and actually decrease profits for banks. Not only that, but he found that interest income and non-interest income correlate more strongly over time, possibly, he suspects, due to cross-selling to bank customers. Non-trading activities, especially those outside of trading, are also more correlated with GDP than interest income, meaning that a shift toward non-interest income tends to make banks more exposed to the economy in general, rather than less.
In other words, 'diversified income' doesn't really mean diversified, and tends to produce higher risk without necessarily generating a higher reward. "
Higher risks without a higher reward. Seems to me that if that's the case, then lower risks with the same rewards makes a lot more sense.
Buy boring and then sleep in
So, complexity on the balance sheet is bad. And complexity on the income statement is bad. Well what is good then?
Good is simple. It's underwriting sound loans. It's investing in conservative securities like treasuries instead of obscure derivatives. It's regional banks that have scale but are not systemically important. It's banks like BB&T .
A quick skim of BB&T's annual report is all you need to see the difference. You won't find any "debit value adjustments", but you will find robust businesses in mortgages, consumer lending, insurance, trust services, and leasing. All businesses that are straightforward, proven, and predictable.
Straightforward, proven, and predictable
Boring banks are not just more stable than their more complex peers, they are also pretty profitable. And with profits comes dividends and share buybacks.
BB&T has provided a dividend every quarter since 1903. That's 111 years, if you're counting. And the stock has performed well compared to the more complex, riskier competition.
Again, this is about taking less risk and getting the same rewards. It's not about getting rich quick; it's about a stable, long term approach to winning.
Success from here is simple. Do nothing.
Collect your dividend check; maybe even reinvest it. The bank will keep collecting deposits, keep funding sound loans, keep blocking and tackling.
BB&T is not the only bank that follows this model. From the community bank on your neighborhood corner to other big, regional players, there are numerous banks that operate this way. It's old school. It's boring. It works.
The key is in simplicity, in high quality assets, and in trusting a model that has worked for thousands of years.
Boring and game-changing
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The article How Lazy Investors Can Get Rich Buying Boring Banks originally appeared on Fool.com.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Bank of America, and Wells Fargo. The Motley Fool owns shares of Amazon.com, Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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