ESQ - On The Hunt For Quality Banks

2024-01-16 01:09:32 ET

Summary

• I am a staunch advocator for banking both as a great business and investment opportunity.
• Berkshire Hathaway once owned a superbly managed and highly profitable regional bank: The Illinois National Bank & Trust Co.
• Analysis of Buffett's letters to Berkshire shareholders between 1969 and 1981 shows that Illinois National's business model had conservative management at the forefront of operations.
• I believe valuing a bank should focus on cash flows and intrinsic value rather than solely book value.
• Finding a great quality bank at a good price is difficult and patience is any investors number one virtue in my opinion.

Why Banks?

Quite simply, I like banking as a business and see real opportunities for great long-term value generation. The fundamental practice of taking deposits at low interest expenses while providing loans at higher interest rates should in theory allow most banks to be highly profitable.

However, if the last 35 years are to show prospective investors anything, it's that this fundamentally simple core business model can be distorted and manipulated resulting in catastrophic consequences as seen with the collapse of SVB in early 2023 and the 2008 financial crisis.

I am an admirer of Buffett's wealth of knowledge when it comes to investing and continuously seek to find any and all relevant pieces of wisdom the Oracle of Omaha may have with regards to making astute investments.

The present unrelenting macroeconomic environment has resulted in many regional banks' valuations hitting rock bottom in 2023. Therefore, I have spent the last few weeks conducting research into a small regional bank owned by Buffett back in the 1970s and the opinions Buffett gave about the operation.

It must of course be noted that what Buffett may believe now with regard to what constitutes a great bank may have changed drastically since the '70s.

However, I believe the macroeconomic conditions of the 1970s share many similarities with those witnessed today suggesting this era of banking could be a good place to start our quest for information.

The following subparagraph arises mainly from Buffett's letters to Berkshire shareholders between the years of 1969-1980 which I have analyzed thanks to an excellent book , "Berkshire Hathaway Letters To Shareholders 1965-2014".

Reports prior to 1977 are unfortunately not available publicly on Berkshire's website.

Where It All Began: The Illinois National Bank & Trust Co.

In 1969 Berkshire Hathaway acquired 97.7% of the stock of The Illinois National Bank and Trust Co. of Rockford, Illinois.

The bank was founded and run by Eugene Abegg, a truly outstanding CEO and businessman whom Buffett commends highly for his cost control, transparency and conservative management style.

Illinois National Bank was a small banking operation with around $100 million of deposits in 1969 and generating around $2 million in operating earnings before security losses in the same year.

This meant the bank generated an earnings before taxes/total deposits ratio in 1969 of around 2% which was a market-leading level of efficiency.

The macro environment in the 1970s was not all too dissimilar from today's economic situation with high rates of inflation and contractionary monetary policy also defining the decade.

Illinois National Bank remained highly profitable despite the difficult economic environment all the while being significantly less exposed to bad credit and essentially never borrowing funds except for occasional reserve balancing transactions.

The bank did this by moving away from demand money to more expensive time money deposits. This resulted in a significant increase in net income expense which was offset by solid deposit growth and conservative loan originations leading to earnings as a percentage of total deposits once again being 2% for 1971.

Illinois National remained highly profitable throughout the 70s with Buffett even uncharacteristically bragging about the bank being " Rockford's leading bank " (1973 Letter to Shareholders) with profitability unmatched even by much larger national institutions.

Ultimately, this great relationship between Buffett, Berkshire, Abegg and Illinois National Bank was brought to an early end by Congress passing the 1970 amendment to the Bank Holding Company ((BHC)) Act which barred holdings companies such as Berkshire from having whole ownership of banks.

On 31/12/1980, Berkshire had divested ownership in The Illinois National Bank and thus this chapter in Buffett's relationship with banks came to a close.

So, What Defines A 'Buffett Bank'?

Considering Buffett's commentary on The Illinois National Bank, I have condensed my beliefs, knowledge, and newly acquired wisdom into a few neat categories that summarize what I believe define great quality banks:

• Outstanding Management

  • I have developed a real admiration of CEO Abegg and President Klein through my studies and further reading into the Illinois National Bank.
  • My favorite characteristics of the Abegg and Kline management combo were their dedication towards cost control, conservative approach to deposits and loans and proactive marketing to consumers.
  • Furthermore, I believe Abegg in particular had a clear passion for banking which motivated him to build a great business.
  • I believe that without excellent management, Illinois National Bank would most likely have been an average bank at best.

  • Key quote:

" With Eugene Abegg running the operation, the exceptional has become the commonplace. " - 1974 Letter To Shareholders

• Profitability & Efficiency

  • Cost control is absolutely crucial when it comes to limiting expenses.
  • The ability to maintain an almost constant headcount all the while significantly expanding deposits and earnings growth is crucial for any regional bank.
  • I believe such tight cost control can enable even small regional banks like Illinois National Bank to be more efficient and profitable than much larger and more moaty organizations.

  • Key Quote:

" Our experience has been that the manager… of a tightly run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors. No one has demonstrated this latter ability better than Gene Abegg. " - 1979 Letter To Shareholders

• Conservative Deposit & Loan Strategy

  • I admire Abegg and Klein's strategy of pursuing "consumer time deposits" (1973 Letter to Shareholders) which enabled the bank to predict cashflows and deposits more reliably.
  • While such deposits may be more expensive for the bank, the benefits of significant deposit growth outweighed the increase in income expense.
  • Illinois National also avoided higher yielding but risky second-class loans with the banks very conservative loan criteria allowing net losses to be just 0.02% of outstanding loans in 1976. (1977 Letter To Shareholders).
  • Such a conservative approach to asset management increases the robustness of a bank and increases the business ability to withstand difficult macroeconomic environments.

  • Key Quote:

"... earnings amounted to approximately 2.1% of average assets, about three times the level averaged by major banks … while maintaining significantly less asset risk " - 1979 Letter To Shareholder.

• Robust Liquidity

  • I am a huge fan of Illinois National Bank maintaining superb liquidity throughout the 70s despite highly inflationary macro conditions.
  • Outstanding liquidity was mentioned in six of Buffett's letters to Berkshire shareholders between 1969 and 1979 which illustrates just how engrained this characteristic was in the bank's operations.
  • I believe that such liquidity can only be achieved through maintaining large deposits at the bank, limiting excessive loan origination and continuing to market to consumers in times of macroeconomic slowdowns.

  • Key Quote:

" The Illinois Bank maintained its position of industry leadership in profitability … while maintaining an unvaryingly strong liquidity position and avoidance of money-market borrowings". - 1973 Letter To Shareholders

To summarize, I believe a high-quality bank must clearly be a leader in profitability, strict on cost control, highly liquid, offer customers a great product and remain incredibly conservative on loan originations.

What About Valuations?

When it comes to valuing a bank, I am particularly keen on not overpaying for my purchases while also maintaining a canny understanding of intrinsic value relative to book value.

One of my favorite two tidbits of Buffett's wisdom comes from the 2000 Berkshire Hathaway Annual Meeting.

Buffett states:

The very best businesses, the really wonderful businesses, require no book value. … we want to buy businesses, really, that will deliver more and more cash and not need to retain cash, which is what builds up book value over time… "

In a 2013 interview with CNBC, Buffett also stated that:

" A bank that earns 1.3% or 1.4% on assets is going to end up selling above tangible book value. If it's earning 0.6% or 0.5% on asset it's not going to sell [at a similar premium]. Book value is not key to valuing banks. "

I couldn't agree more with the shift away from pure P/B metrics. From an investment perspective, bank stocks fundamentally are no different from tech stocks, industrial stocks or even retail stocks.

The cash flow a business will generate over a set period of time discounted to present value is what I believe to fundamentally define value-oriented investing. Therefore, while I do find P/B ratios quite useful for banks, they are no substitute for diligent intrinsic value calculations based on cash flows.

I traditionally like to look for high-quality banks that have become undervalued as a result of an inherently irrational Mr. Market pricing these great equities at the wrong price.

It makes no sense to overpay for a great quality asset from an investment perspective given the utmost impact the concept of a margin of safety has on the median return on investment for any given equity.

Do These Concepts Still Apply 50 Years Later?

Many of the characteristics that Buffett talks about align largely with my own beliefs about banking as an industry and business today.

The collapse of SVB acts as a truly textbook illustration of the continued importance liquidity, maintaining a conservative approach to asset risk and cost control has on the long-term viability of a banking operation.

SVB's apparent disregard for asset risk combined with an excessive loan to deposit ratio and insufficiently diversified loan portfolio ultimately led to the bank's collapse. From my perspective, SVB failed to follow even the most basic of fundamental banking principles.

Great management is another element of banking that, much like Buffett, I still value incredibly highly in today's economy. This point could not be more clearly illustrated by the comparison between Ken Lewis, Bank of America CEO between 2001-2009 and Brian Moynihan who took over from Lewis and still runs the bank to this day.

Under Lewis, Bank of America pursued risky credit in hopes of generating greater returns on assets with the sub-prime mortgage crisis of 2008 exposing just how far the bank had run from their original underwriting criteria.

Since Moynihan has taken the helm, Bank of America has strengthened its liquidity position, decreased exposure to risky credit and insisted on maintaining a highly conservative securities portfolio.

Today, Bank of America is one of the best capitalized and well-run banks in the entire world at least in my opinion. This could not have been achieved without an excellent leader steering the bank in the right direction.

Considering all these characteristics, I would have to say Buffett's '70s era wisdom on what makes for good banking fundamentals still rings true even 50 years later.

While the world of banking may be very different today with regards to digitization, automation and the emphasis on online solutions, the fundamentals of what makes a bank profitable appear to have changed very little.

How To Find Great Quality Banks?

Unfortunately, finding great quality banks is difficult.

Some metrics such as the income per employee statistic can begin to paint a picture of how lean a banking operation is from a cost perspective. ROA and ROE metrics are also an easy way to identify how well a bank is able to generate returns from its business.

However, the very factors that inherently define a great quality bank (conservative balance sheet, diversified loan portfolio, great quality management and low expenses) are a complex mix of quantitative and qualitative elements.

This means efficiently screening for such high-quality banks can be very difficult. Quite simply there is no substitute for the scouring of earnings reports, web calls, and investor relations material.

Nevertheless, through my research over the last few weeks into over 150 regional banks in the United States, I found a handful of oddball banks that stood out by having great liquidity, returns, stability and solid loan portfolios.

I believe these ten institutions could be potentially high-quality regional banking finds:

• ( PFBC ) Preferred Bank - Los Angeles, CA
• ( EWBC ) East West Bancorp - Pasadena, CA
• ( TFC ) Truist Financial - Charlotte, NC
• (SMAL) Summit Bancshares - Oakland, CA
• ( BOH ) Bank of Hawaii - Honolulu, HI
• ( ESQ ) Esquire Financial - Jericho, NY
• ( LKFN ) Lakeland Financial - Warsaw, IN
• ( NECB ) Northeast Community Bancorp, White Plains, NY
• ( CUBI ) Customers Bancorp - West Reading, PA
• ( SFBS ) ServisFirst Bancshares - Birmingham, AL

I must also note that while many of these banks are in my belief robust and well-run organizations, valuations vary significantly.

Quite a few of my favorites trade well above their tangible book value per share and at pretty pricey valuations relative to a discounted cash flow analysis too.

Nevertheless, I maintain a continuously updated watchlist of my favorite regional banking gems and will be writing extensive in-depth analysis on a number of the aforementioned possible Buffett-style banks in the coming weeks.

For further details see: