The idea for this post came from a question from a reader –
Rohit – you gave us the ingredients in the last two posts on banking (see here and here for various factors on analyzing banks), but these ingredients or factors alone are not sufficient. Where is the recipe? How do i combine the various factors to come up with a final decision or idea?
This is a very interesting question, and I plan to publish a post on how I would combine these factors to arrive at a decision.
The analogy with cooking
Most of us have watched cooking shows or would have seen recipes in a book or a magazine. These cookbooks list out the various ingredients with the precise amounts and then they guide you through the steps of putting these ingredients together to come up with a final dish.
Personally, I am an atrocious cook – I can even burn water :). There have been times when my wife has given the list of ingredients and the exact steps and yet I have managed to mess up the dish completely. Even if you are not as horrible a cook as I am, you must have had the experience that inspite of the following the recipe to the T, the final dish does not come out as good as you thought it would.
There is an art to cooking and after all the instructions and teaching, there is no substitute to practice and experimenting. One tends to get better at it over time and there are subtle nuances that cannot be written in a cookbook (which is why old grannies can cook great food, without any formal training).
If you think of it, there is a lot of similarity with investing. I can tell you all the factors and maybe some kind of recipe , but in the end there is no substitute for actually doing it. You may mess it up once a while, but over time if you are interested in the craft of investing, it will work out for sure.
The case for fund managers or chefs
Now that I have decided to bring in the analogy of cooking, let’s take it a step further. Even if you can cook, you still prefer to go to a restaurant to eat once in a while. The reasons are many – variety, better food, less effort etc.
The case for mutual funds or PMS can be similar too. You may be able to invest well if you worked hard at it, but a lot of times you have other priorities in life and would like to hand over the job of investing to a professional (hopefully a good one) who does this full time.
The same logic applies to almost everything else – otherwise we would be growing our own food, milking our cows and doing most of the other basic work too.
The need for oversight
If you decide to outsource some aspect of life, it does not mean that you should ignore it completely. Do you hire a carpenter or a plumber for some job, pay him cash and ask him to do whatever he wants with no oversight from anyone ?
Why should it be different for a mutual fund or a PMS ?
On the other extreme, do you instruct or monitor every nail that you carpenter hits ? Evaluating weekly or monthly portfolio performance is akin to that.
Irrationality in money
The reason the above points raised by me sound funny or absurd is due to the irrational relationship we have with money. A lot of people either ignore it completely (and hope things will work out) or think it is a form of entertainment to invest money / trade in the market.
I can think of only one rational reason for investing – wealth creation. You invest money so that you are able to build an adequate amount of wealth over time which will help you to realize your goals such as retirement, healthcare or children’s education etc. All of the rest – whether you beat the market by X % or find a hot stock is fluff.
By the way – Although I invest my own money, I will never eat my own cooking unless I want to torture myself :)
May 31, 2011
May 23, 2011
Evaluating banks - More factors
In the previous post, I covered several important variables in analyzing a bank. These factors are a good starting point in evaluating a financial institution, but they are not sufficient to arrive at a conclusion.
I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)
Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.
In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.
Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.
However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.
The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.
Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.
The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.
The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.
Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits - which means lower spreads and thus lower margins
In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.
Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.
So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.
Let’s now look at additional factors which are not commonly followed
Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?
Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.
For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.
So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).
The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.
If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.
The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.
Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.
If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think
Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).
I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.
No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)
Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?
Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.
Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)
Management
We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.
For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.
Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)
Are you exhausted :) ?
We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.
I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)
Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.
In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.
Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.
However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.
The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.
Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.
The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.
The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.
Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits - which means lower spreads and thus lower margins
In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.
Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.
So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.
Let’s now look at additional factors which are not commonly followed
Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?
Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.
For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.
So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).
The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.
If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.
The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.
Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.
If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think
Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).
I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.
No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)
Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?
Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.
Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)
Management
We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.
For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.
Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)
Are you exhausted :) ?
We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.
May 11, 2011
Evaluating banks - Key factors
I recently started analyzing financial institutions such as brokerages, banks and HFC (housing finance companies). I wrote about brokerage firms here and here.
In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.
Key factors
Return on equity – This is a critical factor in analyzing a bank. A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.
An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.
CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.
The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)
Net or Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books. A low number is always good. An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA
This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.
Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.
The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.
Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits. The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.
An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.
Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .
NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.
This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)
NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.
There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.
Next post : More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.
In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.
Key factors
Return on equity – This is a critical factor in analyzing a bank. A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.
An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.
CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.
The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)
Net or Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books. A low number is always good. An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA
This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.
Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.
The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.
Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits. The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.
An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.
Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .
NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.
This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)
NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.
There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.
Next post : More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.
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