The Hidden Value in Banks

The once risk-free bank investment has gone high-risk, but diligent investors can still find institutions that yield superior returns.

March 1 1992 by Paul H. Allen And Chandrika K. Tandon


Conventional wisdom holds that banks are conservative, use long-term investments with low risk, and get low, steady returns. Therefore, they used to be a classic “widows and orphans” investment. On its face, the banking business couldn’t be simpler: Collect deposits at one interest rate and make loans at a higher one. Your profits come from the difference between the two rates. Anyone who watched bank stock valuations fall off a cliff in 1990, only to rise 70 percent in the first three quarters of 1991, knows the conventional wisdom is wrong.

What’s happening to banks? The past year has seen some of the largest bank mergers in history. Politicians are hotly debating what shape, if any, the banking “reform” bill will take. The economy is in recession, putting pressure on loan values while making deposits cheaper. And foreign banks and new investors are pumping capital into New York, New England, and Chicago. How can stock investors find banks that will survive these pressures and, indeed, turn them to their advantage? The answer is deceptively simple: Those that achieve robust, sustainable profits from completely redesigning the bank’s day-to-day operations will realize significant increases in stock price. Time and again, we have found that a focused and aggressive restructuring effort that radically departs from conventional wisdom can double pretax earnings in 18 months. Obviously, these earnings gains can translate into a significant rise in stock price, since doubling return on equity from, say, 8 percent to 15 percent leads to an improved market/book multiple of from 0.8 to 1.5 times.

There is still attractive hidden value in many specific banks and consolidation plays. However, such value is hard to realize; moreover, only specific institutions and management teams will be able to tap it. Successful investors will be those who have found institutions whose management has the will to restructure fundamentally the bank’s earnings profile. Management must show the ability to move away from market share-and balance sheet-growth at any cost, toward a more rational method of developing and delivering the bank’s services. The success of this effort will be the defining element between outstanding and disappointing investment returns.

Picking banks that cannot or will not change can be quite costly. There will continue to be a wide divergence between investment returns in banks with and without strong and innovative management. Overcoming confusion about the industry and finding the combination of managerial will and skill to restructure the bank’s operations will be the investor’s key to financial rewards.

WHY THE CONFUSION?

In an industry that is supposed to have safe, steady returns, why is investing so difficult? The opaque nature of the business itself contributes to investor confusion. Put plainly, an outsider cannot accurately analyze credit risk or the value of existing businesses. Even insiders, who can assess loan quality and management closely, are often burned-witness the credit problems at Wells Fargo and Sovran after Warren Buffett and C&S bought their respective interests. A few years ago, Citicorp’s chairman spent $2.5 million of his own money on common stock; recent problems have probably cost him 60 percent of his investment. And, overall, Citicorp raised $750 million in preferred equity in 1991, only to write off $900 million in the third quarter alone. Aside from asset quality, valuation is made difficult by a bank’s peculiar cost structure. Product lines-lending, trust and estate, deposit gathering-all share operating and delivery systems. A bank’s distribution and data systems serve all these markets simultaneously, so it’s impossible to get an accurate cost figure for providing a particular product or serving a particular market. Conversely, it’s impossible to get an accurate figure for the cost savings associated with exiting a market or discontinuing a product.

WHERE IS THE HIDDEN VALUE?

The short answer to this question is everywhere. However, if the nature of the business makes investors confused, traditional financial models won’t work, and regulatory issues blur investment valuation, how can you pick the stocks with the best potential? The best way is to find banks whose management can and will fundamentally restructure the way the bank conducts its business. The average bank today spends 3.7 percent of assets per year on operating costs-salaries, rent, computers, and the like. That’s up 35 basis points-over 10 percent-since March 1990. Even allowing for assets sales and balance sheet downsizing, that’s disconcerting. Finding a way to reduce the costs of doing business, without alienating customers or staff, can at once give management the wherewithal to fund strategic initiatives and take market share from competitors, thereby raising both short- and long-term earnings and stock price.

SORTING IT ALL OUT

How then can investors develop the vision required to find attractive bank stocks as the environment gets fogged? While the recent bank stock volatility, which shows no sign of abating, will require investors to have a healthy stomach for risk, the recent restructuring activity provides a good selection of institutions on which to base long-term investment strategies. The decision to go long or short will rest largely on the bank’s demonstrated ability to run itself-and consolidate acquisitions-with the level of cost efficiency and revenue sophistication needed to compete in the new environment.

Good banks to buy include BancOne, which has created a science of consolidating acquisitions, and NCNB, which will now realize the potential left in the mismanaged C&S/Sovran merger. Society Corp. has shown its consolidation skills twice in two years, first with Trust Co., and more recently with its aggressive Ameritrust plans. Chase Manhattan has been successful in its operational restructuring efforts. First Empire and Bank of New York also have very good track records.

Good banks to sell short based on their apparent skill level today include those that have yet to demonstrate deep restructuring skills, such as Citicorp and the two “equal partners” in the Chemical-Manufacturers Hanover merger. First Union, which had trouble digesting Florida National Bank, may have similar-and more costly-problems with Southeast.

Investors must expand their due diligence beyond traditional balance sheet and income statement analysis. Truly successful investors will focus on identifying the specific alliances of capital and expertise that have the will and skill to unleash superior investor returns.


Paul H. Allen and Chandrika K. Tandon are co-chairmen of ALTA Limited Partners, a New York-based firm that specializes in bank investments and restructuring bank operating performance.