Street Capitalist: Event Driven Value Investments

I recently had a chance to interview Dave Carlson of Tourmaline Advisors on his investment activities in insurance stocks. I think that insurance is a really interesting business, but some value investors totally stay away from financials because they regard them as too complicated. At the same time though, Warren Buffett has been active in the insurance industry for decades — his hiring of Todd Combs seems to indicate that he believes being able to analyze and invest in financials is important.

So I thought it would be a good idea to interview Dave and get him to shed some light on how he analyzes insurers, I hope you enjoy the interview. Feel free to post follow up questions in the comments section.

1. Can you give us some background on why you got into value investing and what got you interested in insurance stocks?

I have to say that my road to value investing has been a series of unexpected turns. Despite growing up where the men on my dad’s side of the family would talk stocks at family gatherings, and my grandfather giving me a book on stocks for my 16th birthday, I had no interest initially in investing. When I started working after college, I began plowing money into mutual funds offered by the company 401K plan as my primary means of investing. When the division that I worked for was sold to another company, I had to make a decision about rolling over my 401K monies.

After spending a month trying to find the right mutual fund, I decided that if I was willing to expend this much effort on selecting a mutual fund, I might as well buy the stocks directly. A family member recommended reading the Investor’s Business Daily and from there I bought some stocks. One of them happened to be American Capital Strategies (ACAS). This was in 1999 and I had overheard people talking about Yahoo Finance message boards. So I started reading the posts on the ACAS board and found an interesting group of fellow amatuer investors. ACAS is a business development company, which not many people fully understand. We spent a lot of time dissecting how the company worked, and this led to other discussions on investing. A group of us enjoyed it so much that we decided to leave the noise of the message boards behind. Our little study group started talking about value investing and relating it to stock decisions. That mix of theory, discussion and application was powerful. From there it just clicked – I was and am a value investor.

My interest in property and casualty insurance stocks is a much simpler story. It was an occupational hazard from working in the industry and why I tend to be cynical about the industry.

2. Why do you think there is increased M&A activity in the specialty underwriting space? Fairfax has done a few of these acquisitions. Do you think they have some kind of moat that allows them to have better underwriting operations? Or are they actually more similar to the rest of the P&C insurance business which has typically relied on investment income?

There are several dynamics influencing M&A at this point. The low valuation on insurers makes it an opportune time to be a buyer. With premiums flat, catastrophes minimal and bond yields anemic, buying another insurer represents a more attractive return. The interest in specialty insurers stems from 1) they tend to have better pricing and 2) there is less overlap because their underwriting focus is narrower. In terms of moat, the property & casualty insurance is largely a commodity business with few moats.

As for Fairfax having a moat, I would say that they have an inverse moat. Sounds crazy but hear me out. They know how to get rid of business, they know how to say no. That is not a moat but a behavior – to be disciplined. Every insurance exec says that they are disciplined underwriters, they’re all from LakeWobegon, but obviously they are not. Insurance is a product sold for which the costs of goods will not be known until a later date, so people can delude themselves by assuming better loss experience. Sort of like the mortgage securitizers who assumed that home prices could only go up. Insurance companies also have a decent amount of fixed costs because you need underwriters, claims people, etc. to support the business, whether you have 50 policies or 5,000 policies. There is a tendency to write any business just to sustain the infrastructure, something you also see in the for-profit education sector.

As for relying on investment income, yes, Fairfax does rely on it more than most. In their annual report, Prem Watsa mentions the net premiums written to statutory surplus ratio, a.k.a. the underwriting leverage ratio. The ratio at the end of 2009 was around 0.5 for Fairfax whereas most insurers are well over 1.0 and closer to 1.5. Watsa has purposely structured Fairfax so that the underwriting contributes less to results. That’s a good thing because it is a lousy business! This also means that the Fairfax insurance companies are overcapitalized relative to premiums written. Once they satisfy the regulatory/rating requirements for safe investments, they are free to invest the excess capital in things besides bonds. The Fairfax business plan comes straight from Buffett.

3. Is pricing and market position maintained through client relationships (i.e. its a small expense overall for the yacht owner and they like/trust their broker)? Is it through branding and market position (i.e. “everyone know that MKL is the place to go for yacht insurance”)?, or is there some actuarial knowledge (other participants aren’t sure they know how to price the business properly so they stay away).

Branding and marketing is a diverse subject within insurance. There are significant differences between personal and commercial, distribution method and line of business. A good portion of insurance is a commodity business, particularly personal lines. Does it matter whether I buy my car insurance from a gecko or a perky sales clerk? No, but the constant bombardment of advertising will at least drive people to get a quote from them. That is important because they rely on direct marketing.

The commercial side is where you see more relationship building, not so much with the insurance companies, but with the brokers, claims administrators, etc. When you get into specialty insurance, like yacht insurance, the number of insurance companies offering coverage shrinks dramatically. It is easier for one or two companies to dominate a market and that gives them an advantage in terms of experience and distribution. The actuarial advantage is a matter of numbers. If you insure 10,000 yachts, your loss experience will be a lot more predictable than the insurer covering 100 yachts. Insurance is all about the law of large numbers. Companies that can mine their own data can create an advantage.

4. What are your top metrics to look at when analyzing an insurance company? Most people seem to hone in on combined ratios and book value — what else do you look at?

Price to book and combined ratio are good starting points. Return on equity, underwriting leverage ratio and investments to equity are other metrics that I look at. On combined ratio, it is also useful to look at the difference between what is reported on a GAAP basis and what is reported on a statutory basis. The “stat” basis is more conservative than GAAP, it’s what the regulators look at, and is a better measure.

I also look at the lines of business written because that influences the combined ratio. For short-tailed lines of business, like property and personal lines, investment income is less of a factor, so the combined ratio should be lower because the driver is underwriting profit. Long-tailed lines, like general liability, can afford higher combined ratios because the investment portfolio is larger and is held longer – the magic of compounding.

5. With most insurers trading below book and it being a soft market — are you finding a lot of opportunities or do you think this is the time to be cautious?

I am more cautious. Insurance companies are essentially levered bond funds, so the extended low bond yields have a bigger impact on earnings. My focus has turned to special situations. I bought a small insurer, Penn Millers (PMIC) after its IPO because it was trading below book value despite having a significant portion of the book value being the IPO proceeds.

Another situation arose with Donegal Goup, which has a unique capital structure. It is a mutual insurer that owns a publicly-traded holding company with two series of shares. The mutual retains control through super-voting “B” shares, which have the same economic interest as the “A” shares. There was some confusion over a deal where they offered to buy a bank, half of which involved “A” shares held by the mutual. The result was the “A” shares trading at over a 35% discount to the “B” shares, which has since narrowed. The other situation is a small specialty insurer, Seabright, which I bought at less than 50% of tangible book value. There was a lot of fear after they took a reserve hit in the 2nd quarter that seemed unwarranted.

6. When you value an P/C casuality company, how do you establish that the reserves are accurate?

When it comes to P&C insurers, reserves are a black box. Outside of being an actuary who can review their claims, there is no way to know whether the reserves are adequate. All you can do is look back over time and see how reserves have developed and whether there have been reserve additions or releases. You have to assess behavior over time. Management can play games over the short-term but eventually the claims get paid and then we find out who is covered and who is swimming naked.

7. How long do you foresee the tail before the insurers adjust their rates for the low bond yields? Do you think we will see a hard market soon?

Let me start with the last question first. Hard or soft markets are determined by capital levels. Prices will harden when capital is destroyed or removed from the space. There is no direct tie to low bond yields impacting pricing but lower investment income means underwriting results will have a greater impact on capital.

8. How do you determine if an insurer is over-concentrated?

Over-concentration is a good question. Some situations are obvious, like Universal Insurance Holdings, a home insurer with most of their business in Florida. That is a binary bet on the hurricane season. Seabright is concentrated in workers comp, with slightly less than half their business in California. The regulatory risk is known by investors, as is their ability to compensate through company-level rate changes and other rating factors. Once you get beyond regional or line of business risk, however, it is difficult to spot concentration.

Even insurers struggle with concentration in their own books. On the property side, technology has allowed insurers to do a lot more catastrophe modeling and to better monitor risk but that depends upon having detailed and accurate location descriptions. The problem on the liability side is that a relatively small segment can have significant losses, as happened with E&O/D&O coverage on financials the past three years.

9. Some insurers are limited to only a few geographic areas — do you discount these because they might face some kind of black swan risk? (e.g.: if you were to only write insurance in TX and a hurricane came, damage could be high but your operations dont have areas outside of TX to draw premiums from to offset the losses)

What I find is that most regionals are very conscious of risk and will buy reinsurance to mitigate the risk. That does not mean that a storm won’t impact earnings but it does not blow a massive hole in their capital. Plus, you do not have to be a regional to suffer major losses – look at what happened after the 2005 hurricane season. In the P&C industry, the potential for a black swan is always present, whether natural disasters, unintended coverage or legislative/judical changes. It is not limited to regionals. I have told my friends that when investing in P&C insurers, cut your normal position in half because you are betting against nature.

You may be surprised that the most that I have ever been invested in insurance was back in 2009 following the March meltdown. I had about 30% of my personal account in insurance, with P&C being about 3/4th of that. Currently, I am about 15% in insurance, all of it P&C. Did I mention that P&C is a lousy business?

10. Have you ever looked at insurance brokers? Do you think they are a better way to invest if you assume the market will start hardening?

I have looked at insurance brokers but have not spent much time looking at them. The top 5 brokers represent something like 85% of the publicly traded market cap and you have at least a dozen analysts covering them. I am not going to add any value to the discussion. Of course, that won’t prevent me from expressing an opinion! My impression is that the brokers are focusing on client needs and have moved away from pure commission fee structures to using a mix that includes flat fees. The brokers will benefit from a hardening market but not to the degree that they once did.

11. Do you ever look at reinsurance companies? How do you get comfortable with the cat risks? Are there any metrics you focus on with a reinsurer that you might look at less when analyzing a short tail P/C insurer?

I do look at reinsurers on a periodic basis. As a group, they tend to track together, depending upon which way the wind blows. As for cat risk, you can see over time how they have diversified into other lines, particularly after 2005. Still, the concern is there and is why they trade at single digit P/E ratios. When it comes to metrics, I use the same ones for reinsurers as for insurers. The only difference is that they tend to trade at cheap than regular insurers.

12. When you value an insurer, what methods or models do you typically use? Is it mostly a matter of looking at multiples and comps? Or is there more to it.

Price to book is really the first metric that I look at, followed by price to earnings. It is simple and objective, as I want to know my margin of safety and then the earnings power. If it is cheap enough that I would be a buyer, then I start digging deeper. Usually, there is a reason that an insurer is trading cheap, so then I try to determine what can change with regard to investment income, underwriting results and expenses. That part is subjective. I do look at comps as a point of reference but not as a buying point.

The Washington Post has a neat infographic on the different budget deficits of the PIIGS:

One day after requesting a bailout worth more than $100 billion, financially troubled Ireland plunged deeper into a political crisis that could complicate a rescue deal with the International Monetary Fund and European Union.

At the same time, concern mounted that attempts to prevent a broader regional debt crisis by shoring up near-bankrupt Ireland may not be enough to prevent the need for more bailouts in ailing Portugal, and perhaps even for the far larger economy of troubled Spain. Coupled with the worsening political turmoil in Ireland, those fears dashed hopes of a market rebound on Monday, rattling stock markets and causing the euro to lose ground against the dollar after initially posting a slight rise.

In Dublin, Prime Minister Brian Cowen, under fire for mishandling the crisis, said he would step down early next year. But he resisted calls to tender his resignation immediately, vowing late Monday to remain in office and push through an austerity budget next month that is considered essential to clinching the rescue deal.

The political crisis potentially poses a new complication in efforts to shore up Ireland. With banks buckling under the weight of a colossal real estate bust, the government is in tense negotiations with the IMF and E.U. over the bailout’s size and conditions. European leaders are pressuring Ireland to reach agreement quickly to bolster market confidence in other debt-wracked countries in the region, as well as to prevent the euro from destabilizing. Britain and Sweden pledged direct loans to Dublin on Monday.

Irish political turmoil complicates financial-system fix (Washington Post)

A friend of mine has been looking at what’s happening in Ireland and passed along the following idea:

I think the Irish crisis for now will play in a similar way to the US one. Liquidity figures globally is pretty strong and these politicians won’t let these banks go under.

I don’t recommend playing the banks. Their upside is going to be ripped to shreds as the Irish/Euro politicos won’t let the outsize profits captured by US banks to happen again in that area.

What people should pick up is companies whose deposits/counterparty/financial risks were tied to banks. So, it would be good to find leasing companies and big users of financial hedges to go long in the Irish space.

I think that this is a great idea in theory because in the US, a number of aircraft leasing companies fell tremendously as worries spread about the risk of their lines of credit vanishing if banks failed (but bounced back when financing fears proved overblown). The problem is I just can’t see a good way of implementing the idea. Yesterday, I paged through the listings on the Irish Stock Exchange, in hopes of finding a company in some kind of business that would be affected similarly. Unfortunately, I didn’t have much luck. I know that aircraft leasing is big in Ireland but it seems as if many of their top companies have been acquired — for example, Genesis Leasing was recently bought by AerCap back in March. Moreover, you need a company with liabilities specifically tied to Irish banks.

If you have any suggestions, feel free to shoot me an e-mail or leave a comment on the post. I think this will be a really interesting spot to watch for now.

Yesterday, the new 13F filing for Berkshire Hathaway (NYSE:BRK.B) came out and for the most part, I wasn’t really surprised. Warren Buffett trimmed some of his holdings but increased his stake in Wells Fargo (NYSE:WFC), Johnson & Johnson (NYSE:JNJ), and a new holding in Bank of New York (NYSE:BK).

via: Dataroma

The new position in Bank of New York is really interesting to me. I have had this theory for a while now that asset management/trust banks would become attractive going forward because of their large fee income businesses.

See, for a long time, most banks operated on this 80/20 model where 80% of revenues came from interest activities (loans) and 20% came from fees (overdraft, credit card interchange, debit card interchange). But that’s changed a bit with the Durbin Amendment which is scrapping the debit card interchange fee from banks. Most bankers have publicly said that they will be figuring out new ways to make up the lost income — most likely by charging customers for things that they take for granted (free checking).

The other model though, might be to acquire financial institutions that are driven primarily by fees. There are a few ways to do this. A bank could acquire wealth management firms that are within their geography — BBVA did this when they came to Houston. Or they could acquire a trust bank, which typically has the income structure split closer to 65/35 than 80/20. We saw one of these acquisitions when M&T Bank (another Berkshire Hathaway holding) acquired Wilmington Trust in an immediately accretive deal.

So where exactly does Bank of New York fit into all of this?

Bank of New York is regulated as a bank but actually derives most of its income via fees. It acts as a custodian for financial assets. As a result, Bank of New York can charge asset management fees to clients, typically at a percentage of AUM. Plus, it can also charge clients on a per transaction basis – so if you expect an increased level of volatility going forward, then the bank should do quite well. This is a great business to be in and throws off a lot of free cash flow when times are good.

The only thing that concerns me about Bank of New York is the company itself. The business they are in is great and should have excellent prospects for the future, but historically the bank’s own results have been less than spectacular. To illustrate, look at BoNY’s EPS since 2000 versus Wells Fargo:

Those earnings seem pretty weak, which makes me wonder about BoNY. At the same time, they have engaged in M&A over the last 10 years, which might have hurt earnings growth — especially if there were integration costs and dilution. Maybe Buffett is expecting some kind of shift in operations, much like what happened with Coca-Cola when he invested.

I’d suggest taking a deeper look at trust banks and banks that have some kind of non-interest fee stream that makes up a greater than 20% portion of their business. This looks like a really fruitful area for some of the bigger banks to do deals and might be beneficial to investors.

Here are some thoughts from the Bank Analyst on troubled banks in the US:

After parsing through bank earnings one thing that sticks out is non-performing loans (NPL) remain high. Tracking NPLs and more particuarly NPL inflow rates will help you determine the amount of problematic loans coming into the pipeline. In any recovery you should see this number decline sequentially and from 4Q09-2Q10 that’s exactly what you’ve seen across most banks. But results from 3Q paint a different picture particularly in one region.

A closer look and you’ll find that Southeastern banks or banks with heavy exposure in the Southeast are starting to see the rate of inflows increase. On surface you may not be able to spot the NPL trends as a majority of these banks have disposed NPLs through sales or a transfer to held for sale which skew the inflow calculation.

Let’s take a look at some of the Southeastern banks that have reported 3Q results:

Regions Financial (NYSE:RF) which has $133 billion in assets and banks in the southeast saw NPL inflows of $1.4 billion compared to $900 million last quarter. The inflows were primarily due to income producing commercial real estate (CRE) and land/condo/single family loans. A quick glance shows at the end of 9/30/10, RF had $3.372 billion in NPLs, down from $3.473 billion last quarter. Taking the difference plus adding back charge-offs of $759 millions gives you $658 million in NPL inflows and implies a solid deceleration given last quarter’s NPL inflows of $900 million. But RF also transferred to held for sale $1 billion in troubled assets which they marked down $233 million skewing the inflow calculation. The actual inflow rate is closer to $1.4 billion when you consider the $658 million inflows + $1 billion in troubled assets – $233 million mark.

SunTrust (NYSE:STI) with $175 billion in assets saw NPL inflows increase to $296 million from $188 million in 2Q.

BB&T (NYSE:BBT) which has $157 billion in assets saw NPL inflows increase to $693 million from $505 million in 2Q excluding troubled asset sales which would make the inflows worse. 50% of BBT’s loan portfolio are comprised of commercial loans.

All three of the banks above saw NPL inflows decelerate from 4Q09-2Q10.

Synovus (NYSE:SNV) mainly a Georgia bank with $31 billion in assets saw NPL inflows increase to $422 million from $339 million after adjusting for the disposition of $172 million in trouble assets. This was the first increase in 5 quarters.

BancorpSouth (NYSE:BXS) with $13.6 billion in assets and banks around the Gulf had NPL inflows increase to $133 million compared to $115 million. BXS had no troubled asset sales.

Whitney Holding (NASDAQ:WTNY) a Louisiana bank with $11.5 billion assets saw NPL inflows improve but announced that it will sell $180 million in troubled loans and reclassify $100 million in additional NPLs to held for sale in 4Q10.

You are seeing inflows pick up in a few banks in the mid-west as well but it is not as widespread as it seems to be in the Southeast region. There could be a few reasons:

1. A slowdown relative to the rest of the US

2.Inflows continue to improve at the bigger banks(ex-C as numbers remain skewed due to their asset disposition strategy) most likely due to having a diversified footprint and loan portfolio. A good amount of improvement is also coming from card portfolios which most regionals tend to avoid. Typically regionals have higher concentrations of commercial, CRE, and mortgage loans which continue to struggle.

3. Banks are finally owning up to their losses.

I am not implying this is a trend and that we’ll see NPLs skyrocket but I do believe NPLs will remain relatively high and we’ll continue to ebb and flow from these levels for quite sometime. It’s a metric worth monitoring.

According to Bloomberg:

Berkshire Hathaway Inc. has hired Todd Combs of Castle Point Capital to manage a “significant portion” of the investment portfolio built by Chairman Warren Buffett.

Combs, 39, issued a letter to partners of Castle Point announcing his decision, Omaha, Nebraska-based Berkshire said today in a statement distributed by Business Wire.

For three years, Vice Chairman Charles Munger and I “have been looking for someone of Todd’s caliber to handle a significant portion of Berkshire’s investment portfolio,” Buffett said in the statement. “We are delighted that Todd will be joining us.”

Buffett Names Castle Point’s Combs to Investment Post (Bloomberg)

Overall, I think that this decision makes a lot of sense. If you look at Berkshire over the course of its history, one of the common trends is a tendency to invest in financials. I’ve often wondered why this is but can speculate that it’s because insurance companies and banks tend to have recurring earnings and the threat of technological obsolescence is pretty low.

So who exactly is Todd Combs?

Combs (39 years old) runs Castle Point Capital, a long/short equity hedge fund focused exclusively on the financial services sector. Formed in 2005, the fund is based in Greenwich, Connecticut. Trident III provided the hedge fund’s seed capital in November 2005.

Here’s what Buffett has to say about Combs:

Buffett described Combs as an “all-American type” who is not the least bit interested in publicity, an attitude unlikely to shield him from it. Now a resident of Darien, Conn., Combs is by birth a Floridian who graduated in 1993 from Florida State University with majors in finance and multinational business operations.

Once out of school he worked for Florida’s comptroller and later moved to Progressive Insurance, where he was involved in the all-important activity of setting automobile insurance rates. Progressive is an arch-competitor of Berkshire’s GEICO.

…Buffett describes Combs’ record through the financial crisis as “pretty good.” Combs’ hiring, in fact, clearly indicates that Combs has had a performance with which Buffett is satisfied.

Meet the leading contender to manage Berkshire’s billions (Fortune)

Performance-wise, Todd Combs looks like a sharp financials investor. According to Bloomberg Castle Point’s fund gained 6.2 percent last year, fell 5.7 percent in 2008, rose 19 percent in 2007 and climbed 13.6 percent in 2006. If you look back over the same period, most financials-focused funds have not had that level of performance. Most took a beating back in 2007 and 2008 and have returns that are closer to the S&P over the same period, if not lower (about -5%).

One of the things I wondered about, back when Li Lu was discussed as a potential CIO candidate (he has since taken his name out of the running) was whether the penchant for betting big and winning huge would be an applicable strategy for Berkshire Hathaway. It’s a practice preached by Charlie Munger, but if you look out at what Buffett has done over the last 30 years, the only big bets have come via the form of acquisitions.

Some of the best plays from Berkshire’s investment portfolio have come from the preferred deals during the financial crisis and the convertible deals back in the 1987 bear market. In both cases, the investment returns had fixed-income properties, returns were capped for the most part, even though he could convert to equity or exercise warrants. These were mostly bets on survival, not on the overall ability for companies to thrive after crisis periods. An investor could have earned a much higher rate of return by purchasing common stocks near their all time lows during either period (similar to David Tepper), but it’s a strategy that Buffett did not pursue. I think that’s pretty telling.

Looking back at Todd Combs’ portfolio, we can see that he was not trying to bet big on any particular direction for financials. He was not doing a Michael Burry/Steve Eisman short the market and make 500% play. I think that is a quality that Buffett was looking for, someone who would perform well but not bet big. Maybe that’s due to the unpredictable nature of financial markets or maybe it’s because he wants the investment side of Berkshire to take a back seat to the operating businesses when he’s no longer around.

Some people have questioned whether investing in Todd Combs, someone with a short track record, makes any sense. To me, the fact that Combs performed so well during a period when most financials investors have gotten crushed is pretty telling. It’s not like we were looking at 5 years of performance during a bull market. So even though 5 years is typically too short of a short timespan, in this case I believe it’s enough to discern whether or not someone is a good investor.

You can view Todd Combs’ top 10 portfolio positions here:

For a full look at his Castle Point Capital portfolio, click this link, to view a google docs spreadsheet with his entire list of positions as of the latest 13F-HR.

Or, view his portfolio embedded in the iFrame below:

via Bloomberg Markets
Be sure to read the accompanying article:

David Tepper often throws a $20 bill on the floor when he’s weighing a big investment with analysts at Appaloosa Management LP.

“Would you pick that up?” Tepper, founder and president of Appaloosa, asks them. His point: The best trades can be like found money.

That was the case in early 2009, he says. Shares of banks such as Citigroup Inc. and Bank of America Corp. were collapsing on rumors they would be nationalized. On Feb. 25, the U.S. Treasury put out a white paper and a term sheet on its Web site for the government’s Capital Assistance Program. They said the preferred stock the government was buying in the banks would be convertible to common shares at prices far above where they were trading — 37 percent higher in the case of Citigroup and 21 percent for Bank of America, Bloomberg Markets reported in its February 2010 issue.

For Tepper, 52, that meant it was time to buy. “If the federal government was putting out this paper, they weren’t going to nationalize the banks,” he says.

Second, the conversion price of the preferred shares meant the bank stocks were seriously underpriced.

“It was crazy,” says Tepper, a Pittsburgh native. “In February and early March, people were in a panic.”

Appaloosa began scooping up bank-related securities, including common and preferred shares and junior subordinated debt. The Short Hills, New Jersey-based hedge fund firm bought into Bank of America, Citigroup, Fifth Third Bancorp and SunTrust Banks Inc. Tepper also bought the bonds of New York- based American International Group Inc., Frankfurt-based Commerzbank AG and London-based Lloyds Banking Group Plc, paying as little as a nickel on the dollar…

Seizing opportunity out of chaos is the philosophy that has guided David Tepper for years. And his investors know it. Even in the midst of the 2008 meltdown, Appaloosa got relatively few redemption orders, Tepper says. In any case, all investors agree to three-year lockups, and Tepper can limit withdrawals to 25 percent of the requested amount.

Still, Tepper says he doesn’t want to gather assets simply for the sake of reaping more fees — a surefire prescription for undermining returns. Five times in the fund firm’s history he has returned investors’ capital when Appaloosa had trouble putting it to work.

If there isn’t a $20 bill on the floor to pick up, Appaloosa isn’t interested.

Bullish at the Brink (Bloomberg Markets)

Unfortunately, the Bank Analyst must remain anonymous. I will say that he works at a large buy-side fund and comes from a value investing background. I think that this interview went really well and you’ll enjoy it. The interview just has a ton of concentrated information about how to look at banks and then perspectives on the sector. I transcribed this from a recording of our conversation, so I everything below is pretty close to word-for-word what was said. I tried to get all questions that were submitted to me answered. Questions and my comments are in bold.

How do you gain a circle of competence with banks? Where do you start?

Keep it very simple. Banks or financial institutions are based around borrowing money and then lending it. So that’s going to be masked by all different types of weird funding mechanisms and odd assets (securities and lending structures). The accounting treatment and regulation will be tricky.

The learning curve especially with the crisis means it’s hard and always evolving. With that giant pot of knowledge you want to keep it very simple. Start out be looking at small micro banks, there are banks trading that might only have 10 branches that operate out of one geography. You can learn that one particular geography and all the macro idiosyncrasies of it. Plus, you can probably talk to management. Keep it simple, find banks that focus on just mortgage lending or commercial and industrial (C&I) lending and master that. Then if you master it you can branch out. If you master mortgages you can branch out to commercial real estate (CRE), then C&I.

Then you could do something like read a Bank of America 10K. They own every type of business within financials. So it might look confusing as a whole but if you think about it individually they are like separate monolines that are operating as a whole.

But yeah definitely start with the simpler banks at first.

What ratios are you looking at the most when examining banks? Do you use the Texas ratio at all given how it has helped signal banks that will need to raise cash in the past?

We don’t really use the Texas ratio specifically. The general ratios that the banks provide you are ok but obviously you can’t just go off of that. There’s much more investigative work. It all starts with a detailed look of the loan/securities portfolios, so type of loans and where they were originated in terms of geography. We look at the different delinquency buckets, non-performing assets, charge-off numbers and make assumptions. It’s a very macro-economic driven process.

Non-Performing Asset (NPA) ratios and charge-off ratios and the rates of their change are important but ultimately it’s the capital relative to the banks assets that’s most important. If a bank has a 4% capital ratio (TCE / TA) and the bank has 5% losses the equity is wiped out assuming they don’t earn their way out. Texas Ratio basically says if all non-performers lead to charge-offs then what percentage of tangible equity would be wiped out, so sort of the same thing.

Do you use any different metrics for regional banks?

No. I wouldn’t say we use any different metrics. Regional banks may not have as many loan categories as the bigger guys. There can be less to look at and obviously its specific to the region. If there is a large discrepancy between the general macro and the regions macro it can make a major difference (meaning a Florida bank may relatively underperform a bank in NJ)

Thomas Brown of Bankstocks argued that the charge-offs to loan reserve ratio had no meaning due to variations in accounting treatment. Can the analyst describe a better criteria for measuring loan reserve adequacy?

There’s some merit to his argument. I’ll give you a simple example: When a bank makes a credit card loan, the reserve to the loan should be higher in theory because it’s an unsecured loan. If it’s a mortgage you can afford to charge off less because there’s collateral backing it up and you’ll have some of the loan recovered in a sale. Obviously the severity is dependent on the economy (if home prices go down). Generally simple reserve ratios may not tell the whole story but when they are headed in one direction quarter after quarter it’s telling you something. If I recall correctly from the specific article where Brown discusses the topic he talks about FHN and how based on reserve ratio, reserves look inadequate but if you look at how those reserves are allocated it seems sufficient. Now you can try to be a hero and pick names that way and claim its thorough analysis but it doesn’t work so well in a banking crisis environment similar to the one we went through.

So should capital adequacy ratios factor in black swan events then?

See – no one knows what that correct capital adequacy ratio (CAR) number is. You don’t know what the severity of the next crisis will be. I’m in favor of keeping the reserve requirements higher than they have historically been. One of the reasons we got in trouble is because the system got way too levered.

How important do you view the funding of deposits? How do you incorporate sources of funding into your investing decisions?

Some people value banks based on deposits — I don’t. I don’t think anyone uses it as the end all valuation. Deposits can make or break a bank. They generally tend to be the stickiest and lowest cost source of funding. With wholesale funding, you’re waking up in the morning praying that some institution is going to keep lending to you. With deposits, you don’t have to worry about that as much.

You want growth in savings loans versus high yield CDs right?

Yeah — the type of deposits is important. If a bank sets them up with hot money CDs, it’s really no different than wholesale funding. GMAC did this. You don’t want a banking institution that does that. You want a depository that people trust and are willing to give you money interest free.

How do you value a bank? Most traditional investors look at things like DCF valuations or try to come up with a Ben Graham style assets-based valuation, but banks are different right?

It’s rare to see a bank analyst use a DCF. We mostly use an earnings model. We then attach a multiple, so what a lot of analysts are doing is attaching the historical 10-12x multiple to normalized earnings.

A simple way of getting an earnings number is by taking a ROA (Return on Assets) percentage and assuming some type of asset growth (negative or positive) and then multiplying the ROA times assets times the growth number. Then, take that number and divide it up by the shares outstanding to get some kind of an EPS figure.

A more detailed model assumes some earnings asset level and net interest margin (NIM) to get net interest income. To get non-interest income you just assume some growth rate off of the fee line items. Then, assuming something on provisions and expenses to get a net income figure. Thats the basic idea and it incorporates a lot of assumptions on the macro and regulatory environment.

During this crisis I think people looked at banks in this manner:

There is a credit/capital concern > people start looking at banks based on tangible book > the concern becomes whether capital is enough. You make your own stress test. If banks pass that you might want to invest in them. Obviously you have to net that against how ouch they will earn too. But trying to earn your way out didn’t really work for Japan.

Ulimately, normalized earnings will depend on GDP and unemployment. If it ends up being robust (so GDP growth rates are high and the unemployment rate goes down) then banks will win but the biggest risk to bank earnings going forward is the level of earning assets. If earning assets decline, normalized earnings will not be as high. The decline in loan balances is something I’m paying particularly close attention to this quarter.

So if a bank has 14% capital and they currently have losses of 3% you are probably in good shape assuming they are not lying or pushing losses into the future. But a bank of that sort might not be cheap either, which can make it a waste to invest in.

What kinds of things do you usually ask management on calls and visits?

Ask whatever you can’t get out of the 10Q and 10K. Understand the intricacies of the business. Find out about specific accounting treatments and things like granular details on their loan portfolios.

Also, trying to gauge how they see the macro-economic environment. The best thing to ask management is to ask what they see in their locale. Look at Case Schiller and see what a specific housing market is doing and then ask a bank there about it. They might say that even if house prices are going up, the unemployment situation still sucks so there’s no improvement.

In Margin of Safety, Seth Klarman says that value investors don’t invest in banks often because their asset books are too opaque. How, when you’re analyzing a bank, do you make sure the assets have a credible margin of safety?

It depends on a lot of factors. 1. The types of loans and geography 2. How loans are performing. 3. Management’s track record in originating loans and honesty. 4. How the macro is performing and 5. How aggressive/conservative management is in working through problem loans.

So dealing with the transparency, that’s a good question. Investing in financials is more of a gamble than any other category. You will simply not have the transparency you have at other simpler businesses. In other sectors management on conference calls can give you line item guidance that you can just plug in your models to come out with next quarter EPS within a small range of error. How many financial management teams got it wrong or thought they wouldn’t be the last one’s holding the bag during the crisis? I remember hearing Ken Lewis (CEO of Bank of America) talking about how the recession will end in 2Q08. And this guy basically gets a real time update on the economy on a daily basis.

So you want a wider margin of safety. If you would buy a company at 6x P/E, you might want to aim for 4x P/E.

Financials are truly a different animal in my opinion. There is no advantage in investing in financials (meaning you are not getting superior moats or higher ROE businesses compared to other sectors) If you thought the market was dead cheap in march for example, there were plenty of businesses in plain vanilla sectors (retail) that had rises greater than or similar to financials and were much easier to understand. Assuming these stocks were undervalued and haven’t gone up for speculative purposes, you can see that car rental company Avis Budget Group (NYSE:CAR) is up 11 fold since its low compared to Bank of America which is up 6x. I would say Avis is a lot easier to understand than BoA.

So why did value investors get it wrong?

As a value investor, investing in a financial requires really getting comfortable with the macro-economic situation. So unless you’re doing some kind of arbitrage (market-neutral) play, you will have to look at the macro. If you want to ignore the macro because Warren Buffett says it is useless then you want to stay away, especially if you’re not benchmarked or don’t have a mandate to invest in financials.

I think that some value investors refused to believe that this time it is different. Also, they just didn’t understand the risks involved with some of the intricacies in financials. Bruce Berkowtiz talks about how he didn’t understand AIG when he read about their derivatives and said pass.

I think that other value investors, especially the ones who decided that AIG was cheap let those risks pass by them. Or they looked at history and said “Okay, this bank trades at 1/2 book and based on history its never been cheaper.” They were wrong.

What would happen to banks in a hyper-inflationary scenario in which the 30-year Treasury yield goes to 15-20% or higher, as Julian Robertson has suggested?

In a hyper or super high rate environment, it will not be good for financials and equities.

The first step would be that asset sensitive banks where loans/securities re-price faster than their liabilities would win temporarily. If you read what SCHW has said, for every 100 bps rise in rates they generate 600 million in net revenues, which pretty much fall straight to the bottom line.

Eventually the dynamic that would kick in would be that depositors would demand higher rates. If rates are 15% depositors wont want 3% CDs. So right there, funding costs would go up.

For a bank to make money, it’s usually an 80/20 split. So, 80% comes from interest income and 20% from fees. Since banks typically generate income from net interest income, they’re going to have to make loans that are higher than their funding costs. The argument is, what homeowner wants to pay a 15% mortgage in a 10% unemployment environment? Credit card rates have already gone up — you’ve seen Wells Fargo and others already do this to try to protect against potential regulatory changes, so that they can keep ROEs closer to a historical level.

I’d argue though that loan demand would collapse. Unless it’s a necessity but I don’t think anybody can raise prices high enough to match that kind of rate environment. Would you pay $20 for a Starbucks coffee? I don’t think so.

So the basic idea here is that nobody will be able to afford those loans and the demand for credit will fall?

So yeah, when funding costs become elevated it’s tough for them to make loans higher than the funding cost. A coffee shop isn’t going to take a loan to buy an espresso maker when the rate is 15%. To make money above their 15% cost you would have to raise prices to the point where no one would purchase a latte. Will that espresso machine make a 15% return to make that a viable expense? I doubt it. Initially, when rates start to rise, asset sensitive banks will win.

So let’s say a bank out there has locked in 5% funding base for the next 10 years. If rates go to 20%, they’re safe with their 5% and they’ll be able to price loans above that easily. Or a bank can become the lender to the government, but if all you’re doing is funding the government that wont work in the long term, as the economy would collapse.

The trade in financials has largely been long large money center and short regional banks. Do you see that trend continuing going forward?

If you start from the beginning, that trade has worked relatively. The best trade was to just long the whole sector. Now I would say that trade is worth holding onto. Ultimately, what I see on the long side is truly diminishing. On the short side there is some stuff but its primarily valuation related.

I want to make clear though that the idea to go long money center banks has had the margin of safety diminish by a lot. I’ll give an example:

Smart and dumb analysts think that Bank of America (NYSE:BAC) is going to earn around $2.50 to $3.00 in 2011 or 2012. What happens if they’re dead wrong? What happens if they earn $0.90 cents? Then you are clearly overpaying for the price it is at today, $17. But when the stock was available at about $3 it was either trading at 3x or 1x. It was very cheap at both of those multiples.

It’s scary because everyone is betting on Bank of America and I don’t like to bet on a horse that everyone else is betting on. If there is a chain reaction of sells on that name it can contract quite a bit.

How worried are you about regionals with large commercial real estate (CRE) exposure as we progress through what seems to be the next set of fundamental problems? And on that note, which regionals would you be most afraid of here?

In the beginning of the year people thought about banks specifically on the basis of what are the banks with early credit stage issues – housing, consumer type loans (credit cards) versus banks with later stage issues like CRE.

So for example: If you see people moving onto land, they’ll build houses. And if companies see houses, they’ll build commercial real estate and expand their businesses there. So in theory, it’s consumer loans that go bad and then goes CRE and C&I. So for regionals, later stage issues are a larger portion of their loan portfolios. We haven’t seen that hit as much as the early stage credit stuff.

CRE is an interesting animal. 1. There’s a lot of weird accounting 2. The structure of the loan itself. So there are these mini-perm loans for example where on the third or fifth year, the principle balance of the loan is due. A lot of these loans were made between 2005-2007. You still have 2009-2011 where things will come due. But a lot of these mini perm loans get extended out a year. So instead of going to non-performing they just get extended out and to all of us we continue to think they are performing.

Fifth Third (NASDAQ:FITB) is one regional that I’m kind of worried about. In general, right, if you’re going to look for CRE issues there’s a few categories: retail, lodging, industrial, and multi-family. Multi-family probably won’t do as bad as other ones because it’s harder to get loans to buy a mortgage. So more people are going to move into apartments in theory but it will still be hit. That might not do as bad as the other types of loans. Retail will obviously take a hit with consumer spending dropping and unemployment levels elevated. Here are some numbers: a basket of regionals – CMA 22.4%, MTB 25%, Regions 21%, Synovus 28%, Zion 35%. If you look at Wells Fargo 10%. Citigroup it is 2% and for BoA it’s 5.75% of loan portfolio. So those guys are pretty diversified versus the regionals that have a ton of CRE exposure. So you have to drill down and figure out the type of CRE they have the geography of it.

So basically it’s a way for management to hide delinquencies using weird accounting treatments?

Exactly. I’d point to the FDIC bank failures. A lot of the failed banks had 2-4% delinquencies in CRE and then a quarter later delinquencies shot up to 30%!. So you don’t really see that in other categories as the increase is gradual Q/Q.

Will majors participate in open market M&A or wait for the FDIC gain deposit share?

A lot of consolidation you saw with PNC (NYSE:PNC) taking over Nat City, Wells taking over Wachovia, I would argue that that type of M&A is less likely in the near term. More of the FDIC bank seizure type will be common

What about straight up mergers/takeovers?

Banks are still worrying about filling holes in their capital base. Even though equity markets have opened up, these guys would likely have to raise money to take over a large-scale bank. Look at Wells Fargo. Once they put on all their off-balance sheet exposure they’ll have a TCE ratio closer to 3%. They’re already in the 4%-ish range. Some of these guys are already too big — a single bank cannot own 10% of the depositor base of the US. You can only do that if you grow the deposit base organically. Not through takeovers, though I think that rule wasn’t considered last year

Can you talk about how you think regulatory / compliance changes that are on the horizon will affect banks? Any key things to watch out for?

One thing that’s known by the industry that everyone is expecting is rules on new capital adequacy ratios. Capital ratios will go up, the system cannot lever as much as it did before. That’s one thing. Fees are going to get hit (think deposit fees, credit card fees). Who knows what will happen if the Consumer Protection Agency goes forward.

I think normalized earnings will go down because of this. I think provisioning rules will change too. When times are good, banks can’t build reserves too high. FASB will argue that that they’re trying to dodge taxes. Do you know how that works?

No I don’t — let’s go into that a bit.

Okay so, when you have to build your allowances for loan losses, it comes through the provision expense. So banks have a reserve set aside, Bank A has $1000 in reserves with $100 in charge-offs. $100 comes out and the reserve is $900 now. If you want to replenish you need to add $100 but if you want to over provide for that you need to add $101 or more, which all comes out of net income.

In good times, some banks might want to provide for more if they think a crisis is coming. The less they provide the higher their earnings will be. The more they earn, the more they pay in taxes. FASB doesn’t want them to build reserves to an amount they think is unnecessary.

It goes back to what Japan was worried about. Their loans stayed in trouble for a long time. I think 25% of Japan’s tax receipts came from financial reserves. So the government didn’t want them to provide for bad loans.

So yeah — it would severely dent tax revenues. So that’s the dynamic here, there’s this quirk in the accounting and regulatory situation.

Exactly. If a bank had foreseen the crisis, they would have had pressure to actually lower reserves. So I think that will change for the better now and that banks will be able build reserves at a higher rate than before.

How do you deal with the government interference and its skewing of natural competition among banks? (i.e.: having the entire mortgage market in 3-4 banks)

Yeah, so there’s always a stigma with government. I think that’s why banks got so depressed in January and March lows. There were a lot of nationalization fears and the stress test looming. Nat City always boggles me because they had 8.7% TCE ratio, they were one of the highest among peers/large banks. For some reason that bank had to basically be sold to PNC. It could have been a depositor’s run.

So you think the government overreacted in cases?

I don’t think government is good at running businesses. So if they start telling banks whom to originate to I wouldn’t want to be a shareholder of that bank. I do think it will have some implications on the lending business going forward.

One thing to add to that, some people are definitely giving the banks that have excessive intervention less of a multiple. Bank X might be worth 8x but Bank Y that paid back TARP might be worth 10x.

Do you agree with that?

Yeah I do. If government flexing their muscles influences operations, if it becomes very big, then yeah. I don’t think government will be as efficient although I don’t think management of banks themselves aren’t so competent or efficient.

Yeah I thought it was interesting that Citigroup had to sell Phibro, even though it’s a profitable and well-run business unit.

Yeah that’s one decent example. Another thing — if you have more programs or initiatives that relax loan standards. If you can’t pay 20% down you shouldn’t buy a house, no matter what the American dream entails. America’s sort of becoming one big bank. They’re doing subprime lending with the FHAs.

What’s your best long and short for the sector? Themes?

I currently ask two questions:
1. What financial institutions are pushing problems to the future?
2. What banks are trying to work through their issues right now and be prepared for an uncertain world?

So how do you tell that?

Find banks that are aggressive in marking down their books and aggressive in raising capital. Or banks that didn’t partake in this excess during the credit bubble. You’ll find these banks; they might not be very popular. Look for well-capitalized institutions that are ready to pick off credits from weaker institutions. It’s sad to say but look for well-connected management. Look at Goldman Sachs (NYSE:GS), a lot of people complain about Goldman, like with that Rolling Stones article. But if you think about it, all those negatives are reasons I’d want to own them at the right price.

So for management, look for guys that are liked by politicians and the public?

So if Warren Buffett were to fall tomorrow, a bunch of guys would be saying all these great things about the life he lived. Angelo Mozilo of Countrywide? Probably not so much. In banking, honesty is super important. It’s important everywhere but I mean — look at IndyMac’s CEO. He was so positive up till the bank collapsed. It’s very unfair and really tough. Some investors really relied on his word and it’s very sad. The good thing about having this period in history is that you can see what management teams handled it well. So if the problems get worse, you can use this period to see if they passed.

I would argue that future crises that come about are likely to be worse. With the way the US is acting these days, with the amount of debt they’re taking on, we’ll probably see more problems in the future.

Commerce Bancorp (formerly CBH) used to be a unique bank that had a different business model. If it were a standalone company now, would it have been affected the same way as most of the big banks? Also, would it have taken more market share from the likes of BoA and Citi.

The thing is, when you go through a system-wide crisis, even small banks are bound to be affected. People always praise Wells but I highly doubt that they picked off the best credits in California while Countrywide and IndyMac were left holding the crap. When you have that big of a loan portfolio, I doubt that whole number is good credits. Obviously it hasn’t been.

So Commerce, their model, Vernon Hill was definitely an innovator. Bank Atlantic tried to mimic it exactly, UMPQ is doing something similar. Ultimately though, it’s the type of loans you make that can bring you down. You can be the most innovative banker in the world but if you make bad loans you’ll go down. Commerce also benefited from having a geographic concentration in the Tri-state area.

Are there any banks in particular that stand out in doing new, innovative things? The future of banking will be different than it is today, which banks are going to be ready for that new future?

I’m sure people can disagree but I’d argue how innovative can you really get in a borrowing/lending model. The medium is changing. We’re seeing more Internet banking and maybe something happens in mobile. When is the last time you actually stepped into a bank branch? My parents do, but not so much the younger generations. There’s banks that offer iPhone apps, so that’s the type of innovation I see but nothing too big. You wont get credit for innovation when you’re in a banking crisis.

Mostly, innovations are used to get cheap deposits. If there is a bank that can innovate and do it correctly, then it can work well. Commerce is a great example of one that did achieve it. Their efficiency ratio was higher than most peers but that’s because they kept their bank open 7 days a week and they made it so you really wanted to visit their branches. They used nice colors, had super friendly tellers (they weren’t stuck behind bullet proof windows or a mini gate), and they didn’t make branches look like a post office or a jail cell.

Their whole idea was putting more money towards non-interest expense but they were able to charge less for deposits since they were more convenient. It definitely worked. If you could invest in safe assets you could earn a wider NIM than peers.

The thing about Vernon Hill was that he wasn’t in the banking business forever, he owned Burger King franchises so he brought over that customer-driven model to banking. But if you run into the storm like we did now, innovation is not a high priority on bank executives’ minds.

If you look at innovation from other areas, like tech, you’ll see guys in college who are really bright that are making websites trying to innovative banks.

Yeah I wanted to talk about that — I always see guys, especially from valley tech startups saying how we need to take the start up model to banking ad really innovate things on that end. Every time, I think this is a recipe for failure with all the regulatory hurdles and work involved.

That’s another good point. It’s a heavily regulated industry. So for someone in college or high school that has a bright idea for starting something in the financial sector, they’re going to go through more capital and regulatory barriers than someone trying to build something like Facebook or Twitter. The roadblocks are just a lot higher.

A lot of times when there’s innovation in financials, it usually comes from within the banking system itself. So it is some guy who has been there for 10 years who sees something and acts on it. But it’s almost never from guys on the outside that think of something one day while sitting in their college classroom.

I would argue that there’s simply a smaller number of brains devoted to thinking about new ideas in banking and it’s mostly limited to people who are already in the financial world because it is within their competence.

What about innovative companies within banking?

There’s definitely people like Dick Kovacevich of Wells Fargo who talks about cross selling at Wells Fargo. There are people who argue that it doesn’t work but to him it’s like the Holy Grail. I’d argue to some degree it has worked because Wells Fargo probably has the best funding out there. I don’t have much experience with their branches since I’m on the east coast but we’ll see how things go with this Wachovia integration.

One thing that a lot of value guys got wrong is that they focus too much on qualitative factors like culture and things on the surface of the business model too much. They focus so much on the positives that they aren’t looking at the risks looming. When you’re sitting there analyzing tech companies, a lot of tech companies have good balance sheets. You’re not trained to look at balance sheet risk. David Einhorn did better on financials than other guys, because they set themselves up to look more at downside. Tom Brown focused too much on culture / qualitative factors and didn’t consider the macro/quantitative reasons that could destroy a bank.

What are you reading right now?

I’m reading Just What I Said by Carrol Baum, a Bloomberg Economics columnist. It’s pretty basic. One thing I learned about banks is that macro matters so much more than you think with banks. You’re almost a macro investor, so on that note I’m also reading Alchemy of Finance by George Soros.

One more basic/beginners book that I really like is Peter Lynch’s One Up Wall Street, that was a book that had a big impact on how I looked at investing when I was younger.

Thank you very much for giving your time for this interview. I know that my readers are going to enjoy it.