Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

A few notes about investing in banks in general.

Buying shares in a bank at the right price can be almost as good as a license to print money. In more normal times, the average bank in the U.S. produces returns on equity of about 15%, a level of profitability mostly associated with the top sliver of businesses in other industries.

I also like the fact that even small banks have moats – barriers to entry – around their businesses. The average turnover rate for deposits is usually well under 20% at a well-run bank, meaning folks tend to keep an account with a bank for at least five years. The secret? High switching costs. For most customers, it’s simply too much of a pain in the tuckus to switch banks once an account has been set up. Habit and inconvenience can be a good thing for the long-term investor. Add regulatory hurdles and the benefits of scale and owning a bank can become pretty downright attractive.

That said, it is not easy for banks to grow – at least, not at rates that those attractive returns on equity would imply. A level of internal growth tied to the regional economy is almost a given, but above that can be a challenge. That’s not necessarily a bad thing for shareholders, though. Most banks pay out the profits they didn’t use to grow as dividends. Or, at least they did in the days before TARP.

In general, most banks try to grow in one of two ways – by gathering as many deposits as they can, or by making as many loans as possible. To an investor, deposit-driven growth is generally more desirable, if for no other reason than only banks can take deposits. As a result, the profitability of that line of business is higher. If a bank can’t fund operations by aggregating deposits, it has to turn to more costly ways of funding itself. Unfortunately, just about anyone can make a loan, and as we saw a few years ago, just about everyone did. This can result in a double whammy to banks, as margins can suffer due to competition and creditworthiness can suffer due to bad loans.

Just how bad that double whammy can get depends on a few things. Let’s review the business model of a bank to frame them.

If you have a checking account or a car loan, you probably already know the basics: a bank takes in money from one group of people, depositors, lends it to another group, borrowers, and profits from the difference. If a bank borrows money from a depositor at 3 percent and lends it out at 6 percent, the bank has earned a 3 percent spread, or net interest income.

Most banks also make money from fees and other services, typically called noninterest income, which when combined with net interest income comprises the bank’s net revenues.

Much more than other businesses, a bank’s revenue and profits are tied to its balance sheet. You’ll recall a balance sheet is the financial statement that summarizes a company’s assets, liabilities and equity at a specific point in time. The balance sheet shows what is owned, what is owed, and what is left over.

On the asset side of a bank’s balance sheet, you’ll find loans and investments, and on the liabilities side you’ll see deposits and borrowings. One important point to understand about a balance sheet is that while the value of assets may change, liabilities are fixed. Since the amount of assets is always equal to liabilities plus equity, any change in the bank’s assets will be reflected in its equity, too.

If the Bank of Margaritaville had $50 million in both assets and liabilities, but no equity, then a small decline in the value of those assets would mean that the bank could not meet its debts. The bank would become insolvent.

So a bank’s equity is a critical cushion for both depositors and bank shareholders.

What sorts of things would cause that equity cushion to disappear? Bad loans, which effectively reduce the amount of assets on a bank’s balance sheet and therefore its equity, too. A constant barrage of bad loans could eventually drain the equity right out of a bank – if the regulators don’t step in and seize the bank first. And that would be bad for investors. Like, drive-off-a-bridge bad.

Banks are unique, too, in that by investing in them you are by definition going to have to tolerate a higher level of uncertainty when it comes to the financials than in any other industry. The books simply reflect a much higher degree of management discretion when it comes to the timing, categorization and/or classification of a wider range of variables. How can you compensate? A margin of safety, as usual, and by placing an extra level of scrutiny on management.

At this point I should note that among the many intangible factors I like about Citizens Republic and its CEO Cathleen Nash are these:

1 – The CEO leading the bank out of its crisis is not the same one who led the bank into it.

The CEO of any bank that would have failed if not for TARP should be canned. If that person remains at the helm, it’s probably a sign of a passive board, complacent shareholders, and/or an executive who is dug in like a tick. None are good.

2 – The CEO has been buying shares in the bank on the open market.

I believe this speaks of leadership. While it’s not a material amount of buying in Ms. Nash’s case, I can nonetheless count on one hand the number of bank CEOs who have bought their own shares recently.

3 – Finally – let’s just acknowledge the elephant in the room here – the CEO of Citizens Republic is from the South. Or at the very least she’s spent a lot of time down here.

So here’s the deal, yankees:

We’ll trade you C-Nash for LeBron – but the clam chowder stays exactly where it is.

Deal?

Kidding. I am a yankee. A yankee named after a race car driver.

Anyway – almost ready to start drilling down. More in a bit.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

The prior post in this series is here. And before we go much further – two warnings about investing in banks in general.

First – much more than most publicly traded business, a bank’s fate is tied to the local economy (or economies) in which it operates. Because of the amounts a bank borrows, its results are uniquely leveraged to the conditions in its immediate surroundings. To invest in a bank solely because it’s statistically cheap is unwise.

When it comes to investing in small banks in particular, it’s a good idea to have a solid grasp of the main drivers of economic growth and all potential headwinds in that particular area. Since local economies on balance will mirror the national economy, having some knowledge of broader macroeconomic trends won’t hurt, either. As I blabbed on about here, I believe the strength of our current economic recovery, though not great, is not as bad as many pundits seem to think, either. I’ll talk more about Michigan’s economy as relates to Citizens Republic later in this series.

Second, there is no investing in regional banks these days without assuming what could be significant risk in terms of commercial real estate (CRE). Commercial real estate loans simply represent a ton of regional banks’ business. So at the risk of greatly understating this: it’s important to do all your worrying about the loan book upfront, before you buy shares.

One of the reasons I’m looking at banks is that I believe we’re already through the worst in the commercial real estate market. Regardless of my opinion, however, by buying shares in a bank that is already priced for the CRE apocalypse but which has enough capital to absorb it, I can be wrong about CRE and still do well as a long-term investor. I’ll write more about construction and development loans a bit later, too.

I am cautiously optimistic about CRE in that vacancy rates appear to have peaked, hotel occupancy is up, and credit, though not great, is starting to flow again. It also seems highly probable that the CMBS market (which packages and sells CRE loans to big investors) will be up and running in time to absorb the loans coming due over the next two to three years. And while there is no way to prove this, I would suspect that most of the really bad CRE loans were already packaged and sold off to CMBS investors. So, to me, and assuming you’re not sitting on a great big pile of crappy securitized loans, the plumbing in the commercial real estate world looks okay – it’s general confidence that is the issue. Plenty of others disagree with me on this point, however, and they could be right. I simply contend that as long as there is a big enough margin of safety in the shares you buy, in the end it should not matter who is more right.

Lastly – jargon alert! – I’d advise investors tread carefully around banks that don’t consider modified or restructured loans to be non-performing. This practice is also referred to as “extend and pretend.” Just this week the Wall Street Journal finally brought this issue the attention it deserves in the popular press.

Banks can reduce the number of defaulted loans they have to recognize by modifying those loans – extending terms or offering low interest rates. However, history has shown that 50% of all modified loans eventually default. It also can be nearly impossible for investors to identify which banks are extending or restructuring loans which management believes are one day going to fail anyway.

So, loan modifications can make a banks’ books look good in the short-term, but there is a fair chance those problems are really being kicked down the road.

Now I can certainly understand the business case for a bank to hold off on foreclosing on a property. It makes all the sense in the world to extend a loan if it increases the chances that it will be repaid – plus, then the bank can avoid having to sell the property in a deeply depressed market. And I don’t believe all banks are systematically restructuring or modifying loans in an attempt to hide the bad ones. But to not consider restructured or modified loans as non-performing in spite of that historically high level of eventual default seems, mmmm, a bit too conveniently optimistic.

So, I am on you like white on rice, SunTrust Bank.

And good on you, CRBC, for doing the right thing – even if only a few of us are watching.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.