June 21, 2007

Margin of safety and banks

I recieved an email from Rohit shah. I am posting the email and my reply to his question below

Hi Rohit,

When you have some time, I request you to elaborate on 'Margin of Safety' principle as propounded by Ben Graham and strongly followed by Warren Buffett. What constitues margin of safety and how does one gauge it?

To give an example, I am trying to apply Margin of Safety principle on my Yes Bank investment in the below way.

My average cost of 115 Vs. CMP 150+. Last 200 Days avg. is 144.

40 Branches now
100 by Mar 08
250 by Mar 2010.
(I am applying a 20% discount here as they don't have good track record on Branch Expansion)

Currently the valuations are running ahead of performance, as Adj. PBV is around same as HDFC, ICICI & UTI Bank though the Branch expansion, higher retail portfolio and higher CASA % will help to improve NIM which is around 2.5/2.7% per last q results.

In 2010 Banking will start getting de-regulated. Yes Bank is positioned as an attractive takeover target due to (1) A greenfield bank with a knowledge driven banking approach (2) Zero levels of Net NPA.

Is this a right way? Are there any other criterias? Need your help with generic thoughts on this, per your convenience.

(I know Buffett perhaps wan't invest in Banking businesses as Capital requirement of 12/13 % means just 1/8 of advances turning bad can have v significant impact. I however like the business model being perpetual in nature + due to my work experience, I have partial eligibility for 'Circle of Competence' principle)

Rohit (Shah)

Hi rohit

Good to hear from a fellow value investor. The concept of margin of safety is actually very simple, but takes a lifetime of learning to apply effectively.

The concept is that one should buy a security at a discount to its conservatively calculated instrinsic value

The key words in the definition are ‘conservatively calculated instrinsic value’. There are multiple ways of calculating intrinsic value with DCF being a key one. Other ways would be to use relative valuation techniques or any other valuation approach which suits you.

The other key word is ‘conservatively’. In the end any price can be justified via a DCF if one makes aggressive assumptions in terms of growth and duration of the growth. So a prudent approach is to analyse the company which is in your ‘circle of competence’, be realistic about the growth and duration of growth assumption and use a probabilistic approach (please see the valuation spreadsheets which I have loaded on my website)

Banks unfortunately do not fall easily in the DCF approach (I have expressed my thoughts on banks on my blog earlier
here and here and here).

Frankly I have not analysed ‘Yes’ bank till date. It is a new bank and should definitely grow. However the business risks are higher and I would not value it similar to HDFC bank which has a much longer operating history. At the same time I do not have a background in the banking industry and do not know how good the ‘Yes’ bank management is. However if you personally have an insight into the management quality, then it may be worth the bet.

Frankly my own analysis of banks is that by the very nature of the business, management quality is far more important in case of banks than any other business and as you pointed out, a management error can easily wipe out the bank . Also with a high leverage, even a few errors can be fatal especially for a new bank. So in the case of ‘Yes’ bank I would assume that the margin of safety will reside in the quality of the management and their ability to achieve the stated growth plans (profitably). I would personally not look at the option of the bank being a takeover candidate in the future. That may turn out to be icing on the cake, but I would not use it as a key valuation factor.

Additional thoughts

1. I look for additional margin of safety in case of banks. The biggest unknown for me is the quality of loans by a bank. NPA’s represent only a partial picture and usually a goes up with a lag if the loan quality is bad. Banks like ICICI bank and others have agressively expanded their retail loan portfolio in the past few years. Are they provisioning adequately? I am not sure but I think the bad debt risk in the retail segment is being under reserved by most banks

2. Management quality make a lot of difference in case of banks. I think by the basic nature of the business, competivitive advantages are weak and high returns are made by those banks which have good management. Bad or over aggressive management can sink a bank very quickly

update : 21st see this article on rising bad loans in retail


RaviAranke said...

Rohit (shah),

It is not strictly true that WB does not invest in Banks. He has held a large position in Wells Fargo for a number of years - the latest numbers show 13.91% in Wells Fargo - which is in top 5 of his holdings.

Rohit C. has indicated a number of factors in assessing banks such as ROE, ROA, NIM etc.

If you are satisfied on the above grounds (and I think for Yes bank there is every reason to be satisfied) then the only 2 questions remain:
1) How long can their competitive advantage be sustained? Since you have some insight into the field, you are better equipped to answer this question. From what I have read, Yes Bank is focusing on innovation and knowledge added products for corporate segment. So this sounds possible.

I prefer niches which a company strongly occupies e.g. Shriram Truck finance. Does Yes bank dominate any specific area?

2) Valuation
I have no idea about adjusted P/B If you could post your calculations, maybe others could take a look.

BTW, there is an yearly (I think) issue of Business Topday magazine that focuses on banks. It has loads of stats on each bank in an easy to compare format. Unfortunately, I didn't save that issue. I purchased 'Federal Bank' based on the info. in the issue and it has worked out OK so far.

All the best,

Rohit Shah said...

Hi Ravi,

Thanks. Very useful suggestions.

Fully agree on Wells Fargo observation. I actually picked up the thought from the book "The Essays on Warren Buffett - Lessons for Corporate America". This is a collection of WB's Letters to Shareholders from 1979 to 2000 & the compilation is arranged, edited & introduced by Lawrence Cunningham. But yes, it's not appropriate to conclude that WB will never invest in a Banking stock.

On Niches, I think YB is recognized for its expertise in Food & Agri business, Life Science, IT Telecom & Media. The analysts expect that this will provide YB the edge over peer banks.

YB Adj. PBV (FY 2009 E) is 3.5 compared to
HDFC Bank & 3.5
UTI Bank & 3.0
ICICI Bank 3.0
Kotak Bank 3.9
Centurion BoP 3.2
(All figures above are FY 2009 E - Source - Angel Broking)

Your suggestion on Banking focussed BT issue is excellent. I will keep an eye.

Sorry, I could not be prompt in replying.

Rohit Shah

RaviAranke said...


I should thank you for highlighting an interesting company.

I browsed through their site and investor preso's etc.

Really liked the following:
1) Owner - managers. It is a strong positive sign that promoters own a significant (above 30%) portion. This is rare in banking sector.

2) Fee based income is about 50% and they intend to maintain it that way. Fee income does not tie as much capital and there is not as much seasonality in it.

3) Focused on corporate sector. Retail portfolio (where the fear of bad loans aka NPA is highest) is in single digits and they intend to keep it that way.

4) Aggressive growth plans as you have mentioned. At the same time, credit policy/ acquisition policy seems to be conservative - which is a good thing.

In short, lot of things to like about.

The only part I don't like is price :( Market seems to know how good a business Yes Bank is.

P/E of 40+ and P/B of 5+ is nose-bleed valuations and all good news seems to be priced in at least for the moment. Current NPAs are at 0% i.e. a squeaky clean record. This worries me a bit as if/when the bad news comes out market is not going to like it.

I guess I will wait on the sidelines for some time and monitor.


Rohit Chauhan said...

i agree with ravi's analysis. The CAR for the bank seems to be around 15-16%, NIM is around 3 % and the rest is through non interest income. The ROA is 2.2% which is also good.
The valuations seem to discounting atleast 7-8 years of 15%+ growth. also everything said and done, the bank is new and does not have a very long operating history. so if i was investing, i would watch the bank , but not invest at these valuations.
if am really looking at investing in a bank at these valuations, hdfc may be a better choice

Rohit Shah said...

Hi Ravi, Rohit

Thanks again for useful observations. I have stopped at the current holdings & waiting for Q1 2007 results to come.

In the meanwhile, just saw the below news today. Not excited by the Rs. 225 target that Management has for fresh equity issue neither today's 9% appreciation makes me any different in my outlook on this stock. YB seems to have revised downwards their targets on Branch expansion compared to what they announced earlier in Analysts calls, to best of my memory. Anyways...


Rohit Shah