Learn from the Worst: Expert

With all the convoluted factors that drive the stock market, predicting which way it will go in the short term is just about impossible.

But wait. A certain group of people that the media refer to as "experts", how are their predictions? These self-assured sounding commentators that we find on TV, the Internet, or print news tell us that they know just what the latest round of earnings reports or economic figures will mean for stocks. After all, they're experts; don't they have to be at least pretty good at predicting economicand stock markt trends?

Unfortunately, research shows that they don't. Let's see how well the stock picks of most "experts" who appeared in the media actually did. Research on this showed there was no consistency or predictability in the performance of these pundits. The best performers in one week, one month, one quarter, six months, or one year were almost guaranteed to be entirely different in the next period; basically, you couldn't make money by picking a top performing expert as measured over a short period of time and following him or her.

"Experts" are far from infallible. A study found the best forecasters - even the "experts" - couldn't explain more than 20% of the toal variability in outcomes. "Consider what this means. On all sorts of questions you care about - Where will the Dow be in two years? Will the federal deficit balloon as baby-boomers retire? - your judgement is as good as the experts'. Not almost as good. Every bit as good." (This was from a 2006 article for Fortune, Geoffrey Colvin examined this concept by reviewing the book Expert Political Judgment: How Good Is It? How Can We Know?)

Colvin also noted that the study found that the experts' "awfulness" was pretty consistent regardless of their educational background, the duration of their experience, and whether or not they had access to classified materials. In fact, it found "but one consistent differentiator: fame. The more famous the experts, the worse they performed," Colvin said.

So, if that's the case, why do so-called "experts" still get so much publicity and air time? The reason is another result of our human nature. As humans, we want to believe the world " is not just a big game of dice and that things happen for good reasons and wise people can figure it all out." And since people like to hear from confident sounding experts who appear to be able to figure it all out, the media likes to give them air time - and the experts like to get that air time because it pays. This relationship was described as a "symbiotic triangle" - it is tempting to say "they need each other too much to terminate a relationship merely because it is based on an illusion."

The bottom line: Just because someone sits in front of a camera with a microphone and speaks confidently doesn't mean he or she has any sort of clairvoyant powers when it comes to the stock market. In fact, the odds are that four out of every five times, they'll be wrong!

Learn from the Worst: The Futility of Forecasting

Having established that most investors - professionals and amateur - underperform the market, the obvious question is, why?

How can so many smart people fare so poorly?

Perhaps, the greatest reason, is the fact that we are human. The way we think, the way we perceive things and feel emotions - has become a major topic in the investing world in recent years. Behavioural finance and neuroeconomics examine how psychology and physiology affect the way we deal with our money. And in general, the findings show that we humans are investing in the stock market with the deck stacked against us.

Zweig authored a book on neureconomics titled Your Money and Your Brain. One of the main points Zweig stressed is that human beings are excellent at quickly recognizing patterns in their environment. Being able to do so has been a key to our species' survival, enabling our ancestors to evade capture, find shelter, and learn how to plant the right crops in the right places. Those are all good, and often essential, things to know.

When it comes to investing, this ability ends up being a liability. "Our incorrigible search for patterns leads us to assume that order exists where it often doesn't. Almost everyone has an opinion about whether the Dow will go up or down from here, or whether a particular stock will continue to rise. And everyone wants to believe that the financial future can be foretold." But the truth, is that it can't - at least not in the day to day, short-term way that most investors think it can.

Everyday on Wall Street, something happens that makes people think they should invest more money in the stock market, or, conversely, makes them pull money out of the market. Earnings reports, analysts' rating changes, a report about how retail sales were last month - all o fthese things can send the market into a sudden surge or a precipitous decline. The reason: People view each of these items as a harbinger of what is to come, both for the economy and the stock market.

On the surface, it may sound reasonable to try to weigh each of these factors when considering which way the market will go. But when we look deeper, this line of thinking has a couple of major problems.

• It discounts the incredible complexity of the stock market. There are so many factors that go into the market's day-to-day machinations; the earnings reports, analysts' ratings, and retail sales figures mentioned above are just the tip of the iceberg. Inflation readings, consumer spending reports, economic growth figures, fuel prices, recommendations of well-known pundits, news about a company's new products, the decisions of institutions to buy and sell because they have hit an internal taget or need to free up cash for redemptions - all of these and much, much more can also impact how stocks mvoe from day to day, or even hour to hour or minute to minute. One stock can even move simply because another stock in its industry reports its quarterly earnings. Very large, prominent companies such as Wal-Mart or IBM are considered bellwethers in their industries, for example, and a good or bad earnings report from them is often interpreted - sometimes inaccurately - as a sign of how the rest of companies in their industries will perform.

• When it comes to the monthly, quarterly, or annual economic and earnings reports, the market doesn't just move on the raw data in the reports; quite often, it moves more on how that data compares to what analysts had projected it to be . A company can post horrible earnings for a quarter, and its stock price migh rise because the results actually exceeded analysts' expectations. Or conversely, it can announce earnings growth of 200%, but fall if analysts were expecting 225% growth.

Here is one more wrench: the fact that good economic news doesn't even always portend stock gains, just as bad economic news doesn't always precede stock market declines. In fact, according to the Wall Street Journal, the market performed better during the recessions of 1980, 1981-1982, 1990-1991, and 2001 than it did in the six months leading up to them. And in the first three of those examples, stocks actually gained ground during the recession.

Learn from the Worst: The Fallen

"From the errors of others, a wise man corrects his own."

We are going to examine how and why investors have failed so that you'll be ready when confronted with the same pitfalls.

The Fallen

It's a pretty crowded place. There are the professionals - the mutual fund managers, the newsletter publishers, and the individual stock pickers.


Mutual Fund Managers

Most mutual fund managers fail to beat the returns you'd get if you had just bought an index fund that tracks the S&P 500. (The S&P 500 index is generally what people refer to when they talk about beating 'the market').

John Bogle (Vanguard Group): From 1983 through 2003, the average equity fund returned an average of 10.3% annually, while the S&P grew at a 13 % pace. A 2.7% spread between the S&P and mutual fund managers' performances may not seem like all that much. But, the compounded returns you get in the stock market can turn that kind of difference into a lot of money very quickly. A $10,000 investment that grows at 13% per year compounded annually, for example, will give you a shade over $115,000 after 20 years; at 10.3% per year, you'd end up with about $44,000 less than that (approximately $71,000).

O'Shaughnessy: "The best 10 years, ending December 31,1994, saw only 26% of the traditionally managed active mutual funds beating the S&P index." That means that just over a quarter of fund managers earned their clients market-beating returns in the best of those periods!

"Less than half of the funds that beat the S&P 500 for the 10 years ending May 31, 2004 did so by more than 2% per year on a compound basis." What's more - this is a key point - these statistics didn't include all the funds that failed to survive a particular 10-year period, meaning that his findings actually overstate the collective performance of equity funds.


Newsletter Publishers

These are investors - some professionals and some amateur - who write monthly or quarterly publications (many are published online) that give their assessment of the economy as well as their own stock picks. They sound official and authoritative and sometimes even have large reseach staffs working for them.

But while they can attract thousands of readers, more often than not their advice is lacking. Hubert Financial Digest monitors investment newsletters and tracks the performance of their picks said in a 2004 Dallas Morning News article that about 80% of newsletters don't keep pace with the S&P 500 over long periods of time.

And just as their individual stock picks are often subpar, newsletter publishers also have a difficult time just picking the general direction of the market.

A National Bureau for Economic Research study of 237 newsletter strategies done in the 1990s found that, between June 1980 and December 1992, there was "no evidence to suggest that investment newsletteres as a group have any knowledge over and above the common level of predictability."

While their advertisements and promises may sound tempting, the data indicates that newsletter publishers and money managers have a weak record when it comes to beating the market. Their collective track record, however, is far better than that of individual investors.


Individual Investors

John Bogle: He has addressed the issue of individual investors' returns and his findings paint an equally glum picture. He told that congressional committee in 2004 that he estimated individuals investors in equity fund has averaged an annual gain of just 3% over the previous 20 years, during which time the S&P 500 grew 13% per year.

Inventory Management

Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.

The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factory would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them.

Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks:

• take up little space,
• minimize stock-holding and
• virtually eliminate the risks of obsolete or damaged stock.

Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management.

The key issue for a business is to identify the fast and slow stock movers with the objectives of :

• establishing optimum stock levels for each category and, thereby,
• minimize the cash tied up in stocks.

Factors to be considered when determining optimum stock levels include:

• What are the projected sales of each product?
• How widely available are raw materials, components etc.?
• How long does it take for delivery by suppliers?
• Can you remove slow movers from your product range without compromising best sellers?

Remember that stock sitting on shelves for long periods of time ties up money which is not working for you.

For better stock control, try the following:

• Review the effectiveness of existing purchasing and inventory systems.
• Know the stock turn for all major items of inventory.
• Apply tight controls to the significant few items and simplify controls for the trivial many.
• Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it.
• Consider having part of your product outsourced to another manufacturer rather than make it yourself.
• Review your security procedures to ensure that no stock "is going out the back door !"

Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges.

Our range of financial planners, Exl-Plan and Cashflow Plan, contain extensive facilities for exploring alternative stock-holding strategies. See also the white paper on Making Cashflow Forecasts and Checklist for Improving Cashflow.

http://www.planware.org/workingcapital.htm

Calculating Cashflow and Cashflow Planning

Calculating Cashflow:

Normally, the main sources of cash inflows to a business are

• receipts from sales,
• increases in bank loans,
• proceeds of share issues and asset disposals, and
• other income such as interest earned.

Cash outflows include

• payments to suppliers and staff,
• capital and interest repayments for loans,
• dividends,
• taxation and
• capital expenditure.

Net cash flow is the difference between the inflows and outflows within a given period.

• A projected cumulative positive net cash flow over several periods highlights the capacity of a business to generate surplus cash and, conversely,
• a cumulative negative cash flow indicates the amount of additional cash required to sustain the business.

Cashflow planning:

Cashflow planning entails

• forecasting and tabulating all significant cash inflows relating to sales, new loans, interest received etc. and
• then analyzing in detail the timing of expected payments relating to suppliers, wages, other expenses, capital expenditure, loan repayments, dividends, tax, interest payments etc.
• The difference between the cash in- and out-flows within a given period indicates the net cash flow.
• When this net cash flow is added to or subtracted from opening bank balances, any likely short-term bank funding requirements can be ascertained.
  

If you need to produce regularly-updated cashflow projections, have a look at Cashflow Plan, our range of fully-integrated cashflow planners which generate projections for 12 months ahead and incorporate a roll-forward facility to simplify updating of projections. Details and free/trial version downloads.

http://www.planware.org/cashflowforecast.htm

Key Working Capital Ratios & Sources of Additional Working Capital

Stock Turnover(in days)
Average Stock * 365/Cost of Goods Sold
= x days
On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management.Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.


Receivables Ratio(in days)
Debtors * 365/Sales
= x days
It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ?One or more large or slow debts can drag out the average days. Effective debtor management will minimize the days.


Payables Ratio(in days)
Creditors * 365/Cost of Sales (or Purchases)
= x days
On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.


Current Ratio
Total Current Assets/Total Current Liabilities
= x times
Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.


Quick Ratio
(Total Current Assets - Inventory)/Total Current Liabilities
= x times
Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.


Working Capital Ratio
(Inventory + Receivables - Payables)/Sales
As % Sales
A high percentage means that working capital needs are high relative to your sales.


----


An example:

Company A monthly inventory = $30
Company A annual purchases = $360
Inventory turnover = $30 x12 / $360 = 1 month = 30 days

The bank gives a interest free facility for the first 15 days; after then, interests will be charged on a daily basis from the first day of purchase.

The company presently uses the bank facility of $30.

How can this company manages its cash flow better? How can this company saves on its interest payment?

Company A can continues to enjoy the bank's interest free facility if it can get its inventory turnover to be less than 15 days. This will free up working capital that can be used for other parts of its business.

To save on interest, company can increase its own working capital by injecting cash in the form of equity or a loan from owners. This cash can be used to settle the bank facility at the time period of 15 days, that is, before the facility incurs interest charges. How much cash should be injected into its working capital for this? To do so, would require (15 days/30 days ) x $30 = $15 cash to be injected in the form of equity or loan by the owners, for extra working capital.

----

Sources of Additional Working Capital

Sources of additional working capital include the following:

• Existing cash reserves
• Profits (when you secure it as cash !)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans

If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading.

Early warning signs include:

• Pressure on existing cash
  
• Exceptional cash generating activities e.g. offering high discounts for early cash payment
  
• Bank overdraft exceeds authorized limit
  
• Seeking greater overdrafts or lines of credit
  
• Part-paying suppliers or other creditors
  
• Paying bills in cash to secure additional supplies
  
• Management pre-occupation with surviving rather than managing
  
• Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).
  

For information on cash flow planning, see Making Cash Flow Forecasts, Cashflow Plan software and Checklist for Improving Cash Flow.

http://www.planware.org/workingcapital.htm

Short-term gain, long-term pain

Just reviewing my transactions in one of my stocks which I have invested since the 1990s. This review starts from May 2006.

The bought and sold transactions since May 2006

15-May-06 xx Bought at 3.98 Present price 8.35 Gain 4.370
31-May-06 xx Bought at 4.06 Present price 8.35 Gain 4.290
13-Jun-06 xx Bought at 3.92 Present price 8.35 Gain 4.430
26-Mar-07 xx Bought at 5.75 Present price 8.35 Gain 2.600
29-Mar-07 xx Bought at 5.95 Present price 8.35 Gain 2.400
03-Jun-07 xx Sold some at 5.3
28-Aug-07 xx Bought at 8.25 Present price 8.35 Gain 0.100
28-Jan-08 xx Sold some at 8.05
06-May-09 xx Bought at 7.70 Present price 8.35 Gain 0.650
05-Jun-09 xx Bought at 7.95 Present price 8.35 Gain 0.400

Stock xxx Avg Price --- Present price 8.35 Gain ---

The present price of this stock is 8.35.

The annual dividend yield of this stock is better than the present FD rate.

Its share price peaked at 9.25 in second half of 2007.

During the severe 2007 - 2008 bear market, the share price was at the lowest of $6.30 in September 2008.



Observations:

There were 10 transactions: 10 buys and 2 sells (partial).

Buying this stock at regular intervals has been profitable.

The prices of the stock bought in the early years were lower than those bought in the later years.

The share price of this stock (good quality company) has reflected its eps and eps growth rate over time.

At the lowest share price of $6.30, the average price of all the transactions were still lower than this market price.

Some stocks were sold for various reasons (e.g. to lock in gains/ or in anticipation of market downturn/ asset allocation/ etc.) in Jun 07 and Jan 08 for 5.30 and 8.05. The present price of this stock at 8.35 is higher than these selling prices.


DISCUSSION:

1. Buying this stock for the long term is safe and profitable.

2. Short term volatilities offer opportunities to buy this stock at bargain prices.

3. The above buying is almost akin to dollar cost averaging (upwards) and it is safe. Dollar cost averaging (downwards) is also safe and probably can give even better returns.

4. Selling this stock at anytime during the 2007-2009 severe bear market and not reinvesting into the same stock at lower prices, gives a lower return than the investor who held onto his stocks during the same period.

5. Lump sum investing into this stock at bargain prices in the earlier years, may give a better return, than dollar cost averaging the same amount over a very long time frame. Dollar cost averaging over a few months (for example 6 months) is almost equivalent to lump sum investing.

6. Timing the market is difficult. Study the above transactions:

• Did this investor buy during the depth of the 2007 - 2009 severe bear market? (This investor has to put in more work on this topic!)
• Did this investor sell at the height of the bull market?

7. In the transactions above, ''buy and hold' strategy can be likened as short term pain for long term gain. In the transactions above, 'buy, sell, and buy back at higher price', can be likened to short term gain for long term pain. ;-)

8. The average price of all the above transactions were significantly lower than the market price almost all the time. This is so even when the market price was at its lowest of $6.30. This gain provides a significant buffer and confidence to the investor of this stock. A value investor would be happy to hold or even load up on this share at the low prices.


CONCLUSION:
It is safe and profitable to buy and hold this and selective stocks.

Selective stocks can be held safely for the long term, even in a severe bear market.

Selling a good quality stock for short-term gain, generates cash which will need to be reinvested. This is not without its associated risks, including, that of not achieving your objective of superior gains in your investments (for example, 15% per year, doubling in 5 years).

Timing the market to buy and to sell is tempting, but is difficult. (trust me on this).

Selling and buying incurs some costs, and when are done frequently, will reduce your returns.

Working Capital Cycle & Working Capital Management

Working Capital

This measures the funds that are readily available to operate a business.

Working capital comprises the total net current assets of a business, which are its stocks, debtors and cash - minus its creditors.



Why it is important

It is vital for a company to have sufficient working capital to meet all its requirements. The faster a business expands, the greater will be its working capital needs.

If current assets do not exceed current liabilities, a company may well run into trouble paying creditors who want their money quickly.

Indeed, the leading cause of business failure is not lack of profitability, but rather lack of working capital, which helps to explain why some experts advise: 'Use someone else's money every chance you get and don't let anyone else use yours.'



How it works in practice

Working capital is also called net current assets or current capital.

Working capital = Current assets - Current liabilities

Current assets are cash and assets that can be converted to cash within one year or a normal operating cycle; current liabilities are monies owed that are due within one year.



What is working capital cycle

The working capital cycle describes capital (usually cash) as it moves through a company:

• it first flows from a company to pay for supplies, materials, finished goods inventory, and wages to workers who produce goods and services.


• It then flows into a company as goods and services are sold and as new investment equity and loans are received.

Each stage of the cycle consumers time.

The more time the stages consume, the greater the demand on working capital.

Cash ----> pay for supplies, materials, finished goods inventory and wages to workers who produce goods and services ---> goods and services are sold and new investment equity and loans are received ---> Cash



Tricks of the trade

- Good management of working capital includes action like collecting receivables faster and moving inventory more quickly; generating more cash increases working capital.

- While it can be tempting to use cash to pay for fixed assets like computers or vehicles, doing so reduces the amount of cash available for working capital.

- If working capital is tight, consider other ways of financing capital investment, such as loans, fresh equity, or leasing.

- Early warning signs of insufficient working capital include:

• pressure on existing cash;
  
• exceptional cash generating activities such as offering high discounts for early payment;
  
• increasing lines of credit;
  
• partial payments to suppliers and creditors;
  
• a preoccupation with surviving rather than managing;
  
• frequent short-term emergency requests to the bank, for example, to help pay wages, pending receipt of a cheque.

- Several ratios measure how effectively and efficiently working capital is being used. (Key Working Capital Ratios : Stock Turnover(in days), Receivables Ratio(in days) , Payables Ratio(in days) , Current Ratio, Quick Ratio, Working Capital Ratio)



Also read:

http://www.studyfinance.com/

Working Capital Management

• Why Firms Hold Cash
• Float
• Ways to Manage Cash

Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

http://www.planware.org/workingcapital.htm

• Working Capital Cycle
• Sources of Additional Working Capital
• Handling Receivables (Debtors)
• Managing Payables (Creditors)
• Inventory Management
• Key Working Capital Ratios
• Introducing PlanWare
• Copyright & Legal Stuff
  

How to assess a banking stock

Nett Interest Income
- Loan Loss & Prov.
+ Non-Interest Income
-----------------------
Net Revenue
- Non-Interest Expense
-----------------------
Profit Before Tax
-----------------------
Profit After Tax (Earnings)


How well is the bank managing these risks: interest rate risk, credit risk and liquidity risk?
Is the bank conservatively managed and consistently delivering solid but not knockout profits?

Get a feel for,

• the kind of lending they do,
• the way that risk is managed,
• the quality of management, and
• the amount of equity capital the bank holds.

Here's a list of some major metrics to consider:
1. Strong Capital Base
2. Return on Equity and Return on Assets
3. Efficiency Ratios
4. Net Interest Margins
5. Strong Revenues
6. Price-to-Book


Find the answers to the following questions before investing into a banking stock:

What is the bank's capital ratio (equity-to-assets ratio)? Compare this to the industry average.

What is the level of loan loss reserves relative to non-performing assets?

Is the ROE in the mid to high-teen?

Is the ROA in the 1.2% to 1.4% range?

Is the efficiency ratio (non-interest expense/net revenues) under 55%?

What is its net interest margin (net interest income/average earning assets? (Most banks' margin fall into the 3% - 4% range. )

Track the net interest margins and ask what is the trend? Is it rising? If yes, why?

• Is falling interest rates pushing up net interest margins?
• Examine the bank's loan categories. Is the bank moving into different lending areas pushing up net interest margins?
  

What is the revenue growth? Is this above-average revenue growth?

• Is this revenue growth due to growth in the non-interest income (fee income)?
• What is the percentage of fee income to the net revenue? How fast is this growing? (Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.)
• Is this revenue growth due to growth in interest income? Is this due to paying slightly lower rate on deposits and charging slightly higher rate on loans?

What is the book value of the bank? What is the Price-to-Book ratio? (The base value for a bank should be the book value. For any premium above that, investors are paying for future growth and excess earnings. Typically, big banks have traded in the 2x or 3x book range over the past decade; regionals have often traded for less than that.)

Hallmarks of Success for Banks: Price-to-Book

Banks' balance sheets consist mostly of financial assets with varying degrees of liquidity.

Book value is a good proxy for the value of a banking stock.

Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value. For any premium above that, investors are paying for future growth and excess earnings.

Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed.

Typically, big banks have traded in the two or three times book range over the past decade; regionals have often traded for less than that.

A solid bank trading at less than 2x book value is often worth a closer look. Remember, there is almost always a reason the bank is selling at a discount, so be sure you understood the risks.

On the other hand, some banks are worth 3x book value or more, but we would exercise caution before paying that much.

Bank stocks are volatile creatures, and you can find good values if you're patient - especially because even the best banks will generally be hit hard when any high-profile blowup occurs in the financial services sector.

Lying up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Strong Revenues

Above-average revenue growth: Historically, many of the best performing bank investments have been those that have proven capable of above-average revenue growth.

Wide margins have generally been elusive in a commodity industry that competes on service quality.

• But, some of the most successful banks have been able to cross-sell new services, which adds to fee income, or
• pay a slightly lower rate on deposits and charge a slightly higher rate on loans.

Keep an eye on 3 major metrics:

• 1. net interest margin
• 2. fee income as a percent of total revenues, and
• 3. fee income growth.

The net interest margin can vary widely depending on

• economic factors,
• the interest rate environment, and
• the type of business the lender focuses on,

so it's best to compare the bank you're interested in to other similar institutions.

Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.

A large and diversified company such as Fifth Third generates more than 40% of its net revenues from fee income, whereas smaller, less diversified companies such as thrifts (e.g. Golden West) get just 10% to 12% of income from fees.

Make sure, therefore, that you're comparing similar companies and that you understand the company's strategy. As always, examine the number over a period of time to get a sense of the trend.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Net Interest Margins

Another simple measure to watch is net interest margin.

Net interest margin
= net interest income / average earning assets

Virtually all banks report net interest margins because it measures lending profitability.

There is a wide variety of net interest margins, depending on the type of lending a bank engages in.

Most banks' margins fall into the 3% - 4% range.

Track margins over time to get a feel for the trend.

If margins are rising:

• Check to see what's been happening with interest rates. (Falling rates generally push up net interest margins.)
• In addition, examine the bank's loan categories to see whether the bank has been moving into different lending areas. For example, credit card loans typically carry much higher interest rates than residential mortgages, but credit card lending is also riskier than lending money secured by a house.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Efficiency Ratios

The efficiency ratio measures non-interest expense, or operating costs, as a percentage of net revenues.

Efficiency ratio
= non-interest expense / net revenues
= operating costs / net revenues

Basically, it tells how efficiently the bank is managed.

Many good banks have efficiency ratios under 55% (lower is better).


For comparison, the average efficiency ratio of all insured institutions in the fourth quarter of 2002 was 58.4%, according to the FDIC.

Look for banks with low efficiency ratios as evidence that costs are being kept in check.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: ROE and ROA

Return on Equity (ROE) and Return on Assets (ROA) are useful for gauging bank profitability.

ROE:

Investors should look for banks that can consistently generate mid- to high-teen ROE.

Investors should be concerned if a bank earns a level of ROE too far below this industry benchmark.

Ironically, investors should also be concerned if the ROE is too far above the industry benchmark too.

• Many fast-growing lenders have thrown off 30% or more ROEs just by provisioning too little for loan losses.
• Remember, it can be very easy to boost bank's earnings in the short term by underprovisioning or leveraging up the balance sheet, but this can be unduly risky over the long term.

ROA:

Besides looking for a consistent mid- to high-teen ROE, it is good to see a high level of ROA as well.

For banks, a top ROA would be in the 1.2% to 1.4% range.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Strong Capital Base

A strong capital base is the number one issue to consider before investing in a lender.

The investors can look at several metrics. The simplest is the equity-to-assets ratio; the higher, the better.

The level of capital should vary with each institution based on a number of factors including the riskiness of its loans, but most of the bigger banks have capital ratios in the 8% to 9% range.

Also look for a high level of loan loss reserves relative to non-performing assets.

These equity-to-assets ratio vary depending on

• the type of lending an institution does, as well as,
• the point of the business cycle in which they are taken.

All of these metrics are found in banks' financial reports, and they can be compared to the industry average.

In the US you can get these figures by logging on to the FDIC Web site, http://www.fdic.gov/.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book