Building The Ultimate Bank Basket
Summary Building a basket is like creating a custom-made ETF. Simple strategies work better than complex systems. The nuts and bolts of building a custom bank basket explained. Investors like to act like art collectors. They spend years hunting for a specific Monet (or a rare investment holding) and are willing to spend anything to prevent it from slipping through their fingers. On the surface this behavior makes sense, good companies supposedly only come along rarely, and investors are rewarded for taking advantage of opportunity. Where the analogy breaks down is that art is supply constrained, there is a limited set of outstanding Monet paintings and no new paintings. There are thousands of traded companies, and tens of thousands of companies are being started every week. If an investor misses one opportunity another comes along quickly. In the world of bank investing, there are over 1,200 banks with tickers that are in theory tradable. Many of these banks are very small and illiquid and only appropriate for experienced and patient investors. But even if one eliminates all non-SEC filing banks from their pool of investments, there are still over 500 SEC filing traded banks. The question becomes: “How does one find bank investments with so many options?” I’ve made a mistake many investors do when faced with finding the best companies in a pile of potential opportunities. I’ve spent far too much time looking at inconsequential details trying to find the absolute best idea. I’ve come to the conclusion that this is a waste of time. Let me explain. Back in 2011 and 2012, I started to look at Japanese net-net stocks. These are stocks trading for 2/3 of net current assets (current assets – all liabilities). Through screening, I identified hundreds of Japanese companies trading as net-nets. The problem was there were more companies than my portfolio had room to buy, so I needed to narrow down the list. Keep in mind that every single company on the list was cheap, the market was valuing all of these companies for less than their liquidation value. What I ended up doing was spending a lot of time comparing companies against each other with metrics that had no predictive value for investment success. I ended up selecting a handful of what I thought were the best companies on my list. My companies did well, but I could have done just as well picking blindly from the initial pool of undervalued companies. As investors we fool ourselves into thinking we’re smarter than we are, and that we can identify the best performing stock from a pool of very cheap stocks ahead of time. There might be a few super-genius investors who can do such a thing, but for the rest of us mere mortals, our best bet to outperformance is by fishing in a very small pond loaded with fish. In the world of bank investing, there are plenty of companies selling at discounts to intrinsic value no matter how you define intrinsic value. For example, I ran a simple screen on CompleteBankData.com looking for banks trading below 1x TBV with a 7% or higher ROE and low non-performing assets and my search returned 10 banks. This might not seem like stringent criteria, but this search finds banks with an above average ROE at less than book value. If I drop my ROE requirement to greater than 4%, more than 30 banks match my criteria. If one were to look for banks earning an above average ROE at less than 1.5x TBV, which is the median TBV value, they’d have 96 banks to analyze. The point is that one can hunt through that list of 10 banks, or 30 banks, or 96 banks and try to identify the top one or two banks to add to a portfolio. Or an investor can take a simpler approach. In the aggregate, these banks are likely to outperform. They are all undervalued, and all have quality assets. It’s far easier to build a basket of banks and gain exposure to an area of the market not covered by ETFs rather than find the best. The second advantage to building a basket of bank stocks is that you don’t need to be an expert on bank investing to gain exposure to a segment of the market. Building your own basket is akin to buying a custom ETF. How to Build a Bank Basket? It’s easy to agree with the concept of building a basket of banking stocks, but sometimes the actual execution is difficult. “What stocks do I buy?” “How long do I hold them?” “How many should I own?” are some of the questions you might be asking about this. Let’s break down how to build an actual basket of bank stocks. Identify an investment criteria The first step is to identify the criteria you’ll use to select an investment. My advice is to keep it simple, simple criteria is better than complex criteria. For example, look for profitable banks selling below TBV with good assets. A screen for this might be: P/TBV < 1, ROE > 1%, NPA/Assets < 3%. Once you have a criteria you're satisfied with run the screen on your preferred screening platform. Sifting for investment candidates I don't recommend buying every company that matches the screen blindly. I put in the bare minimum amount of effort validating data and criteria matches. Sometimes a bank will report a high ROE as a result of a onetime gain. Or a bank might have quality assets in one or two recent quarters but struggled with significant issues in the past. Or sometimes a bank will match a screen but is in the middle of a merger or another transformative transaction. I quickly go through my matches and remove these companies. Buying and holding Once you've identified your basket candidates, it's time to buy them. If you like a clean separation of basket holdings versus non-basket holdings, I'd recommend opening a new brokerage account for these banks. Buy them as you would any stock, use limit orders and be patient in getting your trades filled. The hardest part of owning a basket of banks is holding them. I recommend at least a one-year holding period if not a three-year holding period for each name in the basket. As some banks are merged or sell, recycle those funds into new names that match the strategy. The hardest part of owning a basket of bank stocks is simply staying still and resisting the urge to tinker with the basket. Best of luck!