Balance Sheet Detectives - How We Analyze Bank Stocks

At Prospector, given our expertise in financial services companies, we believe we possess an edge in analyzing banks. Our long-term performance bears this out, especially in periods of distress like the Global Financial Crisis. So, what do we look for when analyzing bank stocks?
Bank Image

Image credit:  CNBC.com

One common theme among our bank holdings is that the majority are significantly overcapitalized. This tends to make the banks less susceptible to the ups and downs of credit cycles and allows for flexibility in terms of capital management. We also favor management teams that consistently return capital to shareholders by way of dividends and buying back their shares.

In general, when analyzing any company, we tend to focus on those that are less complex and easier to understand. Therefore, when analyzing banks, we seek out those that have clean “vanilla” credit profiles, which are easier to dissect. Smaller regional banks usually are a better fit for us in this regard. These smaller banks tend to have less exposure to market making activities, esoteric assets and complicated derivatives. We also avoid balance sheets with exposure to high risk loan categories like speculative construction and development, retail commercial real estate, non-owner occupied commercial real estate and subprime consumer loans. Another benefit of smaller banks is they often fly under the radar with fewer analysts covering them which can lead to meaningful dislocations between market value and intrinsic value (creating opportunities for us to capitalize on).

The banks we own tend to be located in geographies we understand well and that exhibit healthy economic growth. Most of these are small regional banks which operate in only one or two states which allows us to make very targeted bets based on rigorous market research. This is preferable to owning an extremely large bank which operates in many states and may have substantial overseas operations, making it significantly harder to analyze along with greater exposure to systemic risk.

We also prefer owning small regional banks that are potential acquisition targets of larger banks. Through in-depth analysis and our own market knowledge we identify the likely acquirers of the bank we are analyzing. From here we create detailed financial models to determine the bank’s private market value based on simulated M&A scenarios. While a paradigm of ours is to invest in banks with significant upside based on their private market values, we also evaluate banks from the point of the seller. We favor banks whose management teams are incentivized to sell given significant option awards, golden parachutes and direct ownership.

Another way we identify opportunities and differentiate ourselves in the evaluation of bank stocks is by utilizing regulatory filings in addition to GAAP/SEC filings. Regulatory filings provides greater depth and insight into balance sheet composition, credit quality and capital adequacy. They are underutilized by many investors, which can provide us with an edge given our expertise and by taking the extra effort.

Last but not least the human element is a key factor of our investment process (this applies to every sector we invest in). Prior to investing in a bank stock we establish a rapport with the management team via initial screening calls and eventually an in-person meeting at one of their primary branches. We do this to better understand the business and to evaluate the intellect and trustworthiness of the management team. It is essential to determine if the management team is competent and good stewards of capital.

Interested in bank stocks? Regulatory filings can reveal a trove of valuable information on banks, including details on loan types, derivatives exposures, capital adequacy and M&A potential, to name a few.  To learn more, download our research paper - Statutory Data: A Trove of Valuable Bank Information

Statutory Data: A Trove of Valuable Bank Information

 

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The views described herein do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. Please review the offering memorandum or prospectus of a Fund for a complete discussion of the Fund’s risks which include, but are not limited to: possible loss of principal amount invested; stock market risk; value risk; interest rate risk; income risk; credit risk; foreign securities risk; currency risk and derivatives risk.

Nothing contained herein constitutes investment, legal, tax, or other advice nor should be relied upon in making an investment or other decision. Any projections, outlooks or estimates contained herein are forward looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur. 

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