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Picking Bank Stocks to Invest In

Choosing Comparable Companies for Banks and Diversified Financial Institutions

This is our second post on analyzing bank stocks. Keep in mind that when looking at banking, the most pure play bank is a bank that takes deposits and lends, charges service fees and invests excess equity in relatively safe fixed income instruments such as investment grade bonds.

All metrics discussed are relevant to bank stocks. However, the modern bank of today is a financial institution with a much more diversified business mix. This is the right approach once a bank gets to a sufficient scale, because there are ample cross-sell opportunities in wealth management, insurance and capital markets (including an investment banking business). Any bank that does not will leave money on the table – whether having to offer wealth management products and insurance through third parties (and taking a referral commission) or forgoing them altogether.

For these banks with the universal banking business model, lending is still the bread and butter of the business, but comparability is more limited because the price/earnings or price/book ratios could be distorted from the influence of the insurance arm or huge mutual fund business. So an HSBC cannot be compared with a Zions Bancorp or Suntrust (which was recently acquired).

Profitability Ratios for Banks

Ultimately, this is what investors should truly care about – how efficient is the bank in turning assets and equity into profit. Now these are not created equal.

Return on Assets for Banks

Return on assets is the net income over total assets. It may be surprising to some people when they look at return on assets for banks that ROA can be 0.5-2% (2% is remarkably high), which seems low. However, remember that the bank is a middleman or intermediary business – it lends money based on finding funds. So if Assets = Liabilities plus Equity, a lot of assets could be a function of more liabilities instead of more equity.

Debt is an asset for financials such as banks – debt is the funding source that helps banks make money. And while Debt/Equity for normal corporates can be as high as 3 times for some utilities and telecoms (book equity), banks will have debt/capitalization that is not comparable.

This ratio helps investors figure out how efficiently they have deployed their assets in order to generate profit. However, it is not that simple because certain assets have lower returns owing to far lower risk profiles such as insured mortgages. Investment banking businesses do not tie up any capital (capital lite) and can contribute to the bottom line.

Wealth management and asset management means that the bank holds assets in trust for clients off balance sheet but collects a fee every quarter – again boosting ROA. There is a lot to digest here, so a higher ROA compared to peers can be meaningless if the performance is not great for the product mix.

Return on Equity for Banks

Return on equity is another great profitability metric, but the problem with both is that they offer a snapshot in time of historical financial performance.

All things equal, a high return on equity is good – for any business, not just banks. It literally means that for each dollar invested in the company, what is the return on that capital for the year. However, if the bank is choosing to not invest in non-interest expense through technology and talent, it can fall behind. Or – if a bank is booking risky loans to juice higher profits and not marking down the risk appropriately, that can have ramifications in the future.

A consistently strong ROE relative to peers is usually a good sign. A good example would be Silicon Valley Bank being a perennial leader in ROE versus mid cap bank stocks in the US. A rising share price is generally correlated with prudent returns on capital over time.

Choosing the Right Bank Stocks for a Buy and Hold Portfolio

To be a good bank investor, an analyst has to see the opportunities available to the bank over the next couple of years. ROE and ROA that is lower than peers for the right reasons, such as the foresight to invest in technology that will be all important going forward or building scale in what will turn out to be a lucrative market (banks have to pay for talent to sign on when building new businesses – especially in capital markets/investment banking), ends up in much better ROE over time.

TD Bank Case Study

A great example is the Toronto-Dominion Bank, which was once a less relevant player in North America. TD Bank acquired a trust, Canada Trust, and adopted their branding – choosing to massively expand their retail network and offer a differentiated strategy in extending the hours the bank was open. Other banks have followed their lead too late – TD is now known as America’s Most Convenient Bank.

An aggressive but selective acquisition strategy along the US Eastern seaboard has allowed TD to expand their deposit base and commercial banking business to an incredible scale. TD chose to expand commercial banking versus their peers that expanded in capital markets before the financial crisis. Timing is everything.

Continued investment and integration expense hurt ROE in the short run, but the dominant balance sheet today has resulted in shareholders speaking to this being the right strategy, given how the TD Bank stock has outperformed the other Big 5 Canadian banks since the Canada Trust merger.

Bank Strategy and Corporate Development

A good bank is winning now and positioning itself to win in the future.

Remember that banks have an undifferentiated product – behind the brand color palette and shiny bank towers, remember that banks all offer the same products. Loans, mutual funds, mortgages, deposit options. Banks cannot compete on rate alone because everyone has the same funding options.

So this is an industry where strategy truly matters and this is why the strategy and corporate development teams of banks are huge compared to industries where the asset matters the most. A petrochemicals plant in Saudi Arabia has location value – no one can source cheaper feedstock while the ability to market the product is easy. Conversely, a bank is a bunch of people with technology that always is in risk of becoming obsolete.

A competitive advantage is carved out through intelligent execution of strategy over several years to even decades. JP Morgan Chase was not a banking titan from day one. They are the modern product of Bank One, Chase and Chemical Bank and JP Morgan (which was at one point only a commercial bank after splitting with Morgan Stanley).

Banking Evolved

The industry is always changing. Even though banking is associated with being stiff and conservative, consider this – in the 80’s banking was a full day affair. People would take a day off to sort out all banking affairs which included at the till diligencing, plenty of identification problems and stamping a lot of cheques. Bank tellers were also offered danger pay for robberies (they still are, but robberies are far more rare today and frankly stupid given advances in technology and surveillance coupled with the migration towards a cashless society).

Tomorrow’s bank will look very different from today’s. Although bitcoin and digital currencies have so far been a bust, expect blockchain ledger technology to expidite processes and for automation to replace expensive labor. Already, banks are pouring money into fintech and artificial intelligence to cut wait times and improve customer service by allowing immediate access through desktop or mobile.

Banks that do not adopt will see margins thin and be swallowed up by larger incumbents. Banks that fail to be nimble will see their business challenged by Google and payment platforms.

The world is becoming a smaller place and the bank of tomorrow will be a global bank. European banks have long struggled with the absence of cross-border capabilities as countries want to retain national banking champions. Without being able to operate in other jurisdictions, this means that countries with scale will win – such as Chinese banks – with their only competitors being international players such as Citi.

An investor needs to know that their investment can survive in a changing world.

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ex investment banking associate

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