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The Banking Advice That Keeps Ringing in My HeadBy
Friday, June 18, 2010
"Banking is a great business, if you don't try too hard," a retired bank community CEO with a strong southern accent told me once.
What? Be lazy? I was always taught to do my best… to try my hardest. What did this guy mean?
Well, we learned what he means over the last three years... Banks aggressively tried to outdo each other, making increasingly risky loans and creating increasingly more exotic deals.
"As long as the music's playing, you've got to get up and dance," the CEO of Citigroup (Chuck Prince) explained to the Financial Times in July 2007. "We're still dancing." He said.
But "when the music stops… things will get complicated." And they did...
Chuck Prince soon lost his job. And the company he ran nearly disappeared – falling from over $50 a share in 2007 to $1 in 2009. Like Icarus in Greek mythology, hundreds of banks flew too close to the sun.
Meanwhile, the advice of that retired bank CEO ("don't try to hard") keeps ringing in my head. Here's another gem from him:
"Steve, you know the 3-6-3 Rule for good banking, right?"
"No, what's that?" I asked.
"You borrow at 3%, lend at 6%, and hit the golf course by 3 p.m."
Sounds funny… But his point to bankers, in his folksy way, is full of wisdom. Stick to your core business. Don't overreach. Do this, and you can hardly fail. Then, when the time comes, you’ll retire with millions in the bank.
Where am I going with this?
I think we're ready to enter a new, more conservative era in banking. The banks that flew too close to the sun are gone.
Those fallen banks should serve as a reminder and a warning to the surviving banks. Maybe – for a few years at least – these bankers will learn the lesson my retired banker friend knows… that "banking is a great business, if you don't try too hard."
And while you might be scared to consider buying banks, the most successful investors on the planet are not. They are loading up in a way I've never seen before.
Hedge-fund legend John Paulson, for example, has put $3 billion into Bank of America stock and $2 billion into Citigroup.
Bruce Berkowitz – head of the Fairholme Fund (a recommendation in my newsletter, True Wealth) – has put 9% of his fund's assets in Citigroup and 7% in Bank of America.
I can see why… Both stocks are trading at 25% discounts to book value – about as cheap as you'll ever be able to buy a bank. Only we can’t know what's lurking on their books… what exotic derivatives contract they wrote while busy dancing could blow them up. The hedge-fund legends obviously believe that’s a risk worth taking now.
It is crazy that banks are this cheap… Keep this in mind: Thanks to the Federal Reserve, banks can borrow money at essentially zero percent interest. When the cost of money for a bank is zero, it should be able to make a fortune! And it should be priced out of this world in the stock market. Instead, banks are at big discounts.
A safe play, if you can find it, would be community banks run like my retired banker friend ran his banks… with nothing fancy on the books. The First Trust Nasdaq ABA Community Bank Index fund (QABA) could be a good starting point. It holds 90 smaller banks with market values in the $600 million range (that's small compared to JPMorgan at $150 billion). For more, visit www.ftportfolios.com and type QABA in the search box.
The secret to successful banking is to "not try too hard." Don't chase bad loans. Stick to what works. If that puts you on the golf course by 3 p.m., so be it.
I don't own any publicly traded banks yet (though I do own shares of a small community bank through a private placement). But I am getting interested…
Banks are incredibly cheap – shares of XLF (a fund of bank stocks) are trading lower than ever, going back to the 1990s. And banks are trading at a discount to book value, which is rare. Even better, banks are now scared enough to not do anything too dumb, at least for a couple years.
I'm going to dig deeper. You should, too…
Good investing,
Steve
Further Reading:
Steve's not the only one thinking about buying banks these days. Tom recently added a few banks to his 12% Letter portfolio. Only Tom has another reason for buying the sector. Back in April, he told us about the opportunity he sees in these essays: How to Profit from the Coming Plague of Busted Banks and Another Way to Profit from the Coming Plague of Busted Banks.
Of course, we have to mention Steve's favorite "virtual banks." He's been telling DailyWealth readers about the unique opportunity in these government-guaranteed "banks" for years. Read his latest update here: Where to Get 17% Interest – Safely.
Market NotesYOU CAN COLLECT BIG INCOME FROM ENERGY TOLL ROADS This week is "income week" in Market Notes. So far, we've covered bonds that trade like ordinary stocks... blue-chip income machines... and legitimate 15% dividends from government-guaranteed investments. If you're looking for more sources of steady income, don't forget "toll road" investments.
Toll roads are great income vehicles: You provide a service people need... you don't have a lot of competition... and once the road is built, you don't need to spend a lot of money on upkeep. The tolls are all profit.
Companies that store and transport natural gas are some of our favorite "toll road" investments. The first thing you need to know about these investments is natural gas is one of the cheapest, cleanest, most abundant sources of energy available to Americans right now. These qualities mean no matter what happens in the rest of the economy... demand for natural gas is going to rise.
Second, these natural gas toll roads don't care what the price of natural gas is. All they care about is millions of people are using natural gas every day... and there's a high demand for their processing, storage, and pipeline services.
Finally – and most importantly for income investors – these companies have a special corporate structure (called an "MLP") that allows them to pass most of their earnings along to shareholders.
Below, you'll find a dividend-adjusted chart of Kinder Morgan, a blue-chip natural gas pipeline company. It had a big run up recently, so it's currently yielding only 7% (compared to 10.5% in March 2009). It's not a screaming deal anymore, but if you're looking for steady income, buy it for the long term on a market correction.
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