March 25, 2024

Y H & C Investments: Investing in Today’s Market- FInancial Services

Y H & C Investments: Investing in Today’s Market

Many years ago Ben Graham wrote the Intelligent Investor, considered the best investment book ever written.  In it, he differentiated between speculation and investment.  Speculation is spending money on something with the belief the price will go up so you can sell it later at a higher price.  Investment is the thorough understanding of what you are spending on, and the calculation of its value versus the price.  If there is enough of a difference between the current price and the calculated value, then it is worthy of investment provided your profit is adequate.  Note the term adequate.  There is nothing there that says you must have a better return than an index.  Let’s consider the current market environment and how this difference is applicable.

Today’s market is dominated by algorithmic trading where 65-76% of the total value is done by computer programs based investment.  Much of this is based on finding patterns in the price of stocks and buying and selling with the idea of profiting from these patterns of prices.  As an example, the analysis may be based on the price of a stock at certain times of the year.  It may be based on a pair trade, where the investment is to buy the stock of the best performing company in an industry, say JP Morgan Chase, and short the worst performing company, like Wells Fargo.  The probability of the algorithms totally understanding the assets they are buying, calculating a value based on their current and future operations, and comparing it to the market price is very low.  If we extend things further where you look at the current prices of many of the leading companies in the market, it is not unreasonable to say our current market is dominated by speculative activities.  With only 10 stocks doing better than the market indexes, it makes for an environment where there are plenty of companies which are underfollowed and ignored.  As such, there is opportunity for the investor.

In my prior discussion of the current market, I noted the distinction between relying on what has worked for the last fifteen years, buying these highly valued market leaders, versus concentrating on owning what I call mandatory assets.  I am going to continue along this path by introducing another industry category, the financial services area.  We should define the group as including commercial banks, community banks, investment banks, specialty finance companies, insurance companies, and payment processing entities.  It is an area I am very familiar with and have long invested in.  The reason why I like these kinds of companies is because they often have a few different business units which are designed to make money.  

If we look at a commercial bank, they take their customers' deposits and offer them a minimal interest rate, and then either loan those deposits out at a higher rate, or invest in a security where they earn a higher return than what they offer their depositing customer.  This is called a spread.  For banks, the key area to understand is what is called net interest margin, or the difference between what they pay out and what they earn.  Banks have different kinds of loan products where they earn this spread.  Loans can be with mortgages on homes, small business loans, or larger loans to bigger businesses.  The large loans are often related to real estate, construction, industrial, or commercial development.

Many banks have segments unrelated to this kind of lending.  For investment banks, it is the underwriting of stocks and bonds for sale to the public.  The investment banks also advise on mergers and acquisitions.  They will also serve as a middleman for buyers and sellers and trade for their own accounts, which is known as market making.  Market making can take place in other kinds of financial instruments besides stocks and bonds.  Market making takes place in swaps, futures, and forwards for interest rates, currencies, energy futures, ETF’s, and other kinds of derivatives (weather related instruments).  Another segment banks often have is asset and wealth management.  The bank takes customer capital and invests the capital for clients to earn a fee.  The asset management piece is focused on investing assets, where wealth management is a more comprehensive approach to an entire financial situation and might include tax and estate planning, retirement planning, health and wellness, and succession issues.  Banks often have payment processing divisions which offer payment services for businesses in credit and debit cards, online store payments, and phone based payments (texts).  

Banks are a mandatory piece of any market based system because they are the foundation for businesses and customers.  If money is involved, it needs to be stored in some way.  Capital must be raised, either through borrowing (debt based instruments) or equity (capital from the firm). Payments have to be collected and distributed.  Retirement plans have to be set up, tracked, accounted for, and distributed.  The different kinds of business lines banks offer mean they often have a more stable business model. 

One major risk for all banks is in the deposit area.  As we saw last year, with technology, customers can now click, click, and move their assets very quickly.  As such, banks can be vulnerable to changing customer perceptions on stability, and deposits can flee very quickly, called bank runs.  It remains the biggest vulnerability for any bank.  In most cases, banks use leverage on their balance sheet.  Conservative banks are leveraged 10X liabilities or less.  The liabilities are deposits and debt employed.  Assets are predominantly loans.  Too much leverage renders banks vulnerable when the assets are underwritten poorly, meaning there are far too many defaults.  Another potential vulnerability for banks is the quality of their loan book.  The primary job of a bank is to loan money, and because a bank typically uses leverage, when loans are poorly written, it can cause a bank to have major capital impairments or potentially fail. The best example of this is Lehman Brothers in 2008.  Another major risk for banks is related to funding, which is liquidity.  When the perception of a bank changes and they are thought to have problems with access to capital, problems can quickly arise.  The best example of this is the fire sale of Bear Stearns, which also took place in 2008.  Operational and reputational risk are related to the deposit, funding, and liquidity issues.  Credit Suisse and Silicon Valley Bank both failed from bank runs related to their operational and liquidity questions.  

The banking industry as a whole has not returned market beating returns over the last few decades.  The industry is highly fragmented in the United States.  There are almost five thousand commercial banks and nearly nine hundred investment banks in the country.  The largest, called money center banks, receive the most attention.  JP Morgan Chase, Bank of America, Wells Fargo, Morgan Stanley, Goldman Sachs, and Citibank are the names most investors are familiar with.  There are thousands of commercial and community banks which offer the same kinds of service but not with the same scale or as many different business lines.  These smaller entities often are excellent places to deploy capital as long as you are willing to understand what the bank does, how good the management team is, and how it plans to grow.  I believe banks are an interesting area to invest and you might consider it as well.  We are focused on investing versus speculation, and it is applicable in various parts of the banking industry. Thank you for reading the article and if you have any questions about investing, please email me at [email protected] or call 702-350-0024.  

(Y H & C Investments has positions in companies mentioned in this newsletter. It is the responsibility of each investor to research the investments mentioned so they can decide on the appropriateness and suitability of the investments consistent with their risk tolerance, risk constraints, and return objectives. Past performance is not an indication of future results, and you may lose your principal by investing in stocks.)

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